International economic conditions are at their weakest for many years. The United
States has all the hallmarks of recession – declining output, sharply
declining profits and investment, falling business and consumer confidence
and rising unemployment. These trends were already in train prior to the events
of 11 September, as the data up to August make clear, and have continued thereafter.
The terrorist attacks themselves were always likely to have only a relatively
small economic impact directly, but their effects on confidence – and
therefore on the willingness of businesses and individuals to accept risk –
are potentially substantial. Gauging these effects is of course a subjective
process, and distinguishing them from what was likely to have occurred anyway
is virtually impossible. But what is clear is that, for a range of reasons,
perceptions of the short-term prospects for the US economy have deteriorated
markedly in the past few months.

At any time, this would be a matter of significance for the world economy. The fact
that it is occurring while other key regions are also experiencing weakness
is all the more cause for concern. Japan remains in the grip of powerful deflationary
forces, a decade after the bursting of the bubble that had taken prices for
shares and land to extreme levels. Many countries in east Asia, and particularly
those which had been able to take advantage of the global technology boom of
the late 1990s, are now suffering the after-effects of the slump in that sector.
In Europe, growth has also weakened noticeably.

Hence it is now clear that global growth in 2001 has turned out to be a good deal
weaker than previously thought, running at less than half the pace recorded
in 2000, and many observers now expect 2002 to be almost as weak. Even the
latter forecast depends on the US economy beginning a recovery during the first
half of next year. The weakening of international economic activity is exerting
downward pressure on prices for internationally traded goods and services.
Many commodity prices have fallen sharply, the price of oil prominently among
them. But also notable is the continued downward pressure on prices for many
manufactured goods, especially, but not only, high-technology goods. Exports
from the major countries, for example, are receiving lower prices than a year ago, and the degree of price decline is larger
for the east Asian producers of electronic components. These influences can
be expected to exert a dampening effect on CPI inflation in most advanced countries
over time.

Substantial adjustments have taken place in financial markets over the past year
or more. Share prices in many countries are 30–40 per cent below their
early 2000 peaks. Bond yields have fallen, and monetary policies have been
eased. Short-term interest rates, particularly in the English-speaking countries,
are at the lowest levels for 30 years. The events of 11 September imparted
an additional element of uncertainty to markets, though the short-term impact
had largely passed by late September. Yet, with consensus forecasts for world
growth continuing to be revised down and great uncertainty remaining about
the economic outlook, a difficult period for markets may still lie ahead. For
their part, markets expect that central banks in major countries will need
to ease monetary policy further in the months ahead.

The most pronounced policy changes have been in the US. The Federal Reserve has reduced
short-term interest rates by 450 basis points since the beginning of the year.
The US government is also giving a substantial boost via fiscal policy. Much
depends on the effectiveness of the US measures, if only because the scope
for policy action in other regions seems, for one reason or another, to be
limited. In Japan, fiscal and monetary measures over an extended period have
all but exhausted the scope for conventional macroeconomic policies –
but have not been able to revive chronically weak economic activity, to prevent
prices falling or to revitalise weak financial institutions. Underlying structural
rigidities in Europe, and the difficulties of building credibility for a new
currency, have limited room for expansionary monetary policy measures to date.
These constraints should ease as inflation pressures subside, but agreed limits
on fiscal balances are likely to become more binding as economies slow.

Were it not for such a gloomy prognosis for the world scene, prospects for the Australian
economy would be for very strong growth in the coming year. Real GDP expanded
at an annualised rate of just over 3 per cent through the first half of 2001,
and this before the upswing in housing construction had really begun. Over
the coming few quarters, as dwelling construction rises, a significant boost
to production can be expected. The decline in non-residential construction
which has taken place over the past two years, also appears to be drawing to
an end. With even moderate growth in consumer spending, these trends suggest
a distinct firming in domestic demand. But at the same time, the externally
oriented sector of the economy – where the rise in the trade balance
added nearly 4 per cent to national income over the past two years –
will find the going much tougher over the next year. Hence it remains the case,
as at the time of the last Statement, that the downside risks to Australia's growth performance
come mainly from abroad.

Surveys of business conditions reflect the strengthening trend in domestic demand,
particularly in construction and sectors which supply it. At the same time,
indicators of confidence about future conditions have shown a noticeable deterioration
in readings taken after the terrorist attacks on the US. Such indexes can give
misleading signals – they foreshadowed a sharp economic slowdown in 1998,
for example, which did not eventuate – and they may be unreliable when
surveying early responses to non-economic events, which could not hope to be
more than impressionistic. Nonetheless, it would be understandable if an air
of caution prevailed as far as financial, investment and hiring decisions were
concerned, at least for a short time. When taken together with indications
of pressure on profitability, and softness in business credit, this suggests
that a significant expansion in business investment which might otherwise be
due may not materialise just yet. An additional factor is the impact of both
a decline in international air travel and the demise of Ansett on the tourism
industry. In the medium term, the effects of these factors will be ameliorated,
and possibly offset, by changes in travel patterns and the supply of additional
domestic airline capacity. In the short term, however, there is a quantitatively
significant impact on tourism activity.

The extent to which business caution may affect the labour market is unclear. Employment
has grown during 2001, following a period in which it declined in the second
half of last year, but the growth has not been strong enough to prevent a rise
in unemployment. Construction and related parts of manufacturing are now seeing
stronger demand, but at the same time several services areas, which had been
strong for some years, now are reducing their demand for staff.

Labour market outcomes will be an important factor affecting household consumption
spending, through both income and confidence effects. To date, modest gains
in employment and real wages, together with income tax reductions, have assisted
growth in consumption. At the present time, this trend appears to be continuing.
Household spending should also be supported by household wealth, which has
continued to increase and is at an unusually high level relative to current
incomes.

For the past year, assessing inflation has been complicated by the price level rise
associated with the introduction of the GST in July 2000, the size of which
was estimated to be of the order of 2½ to 3 per cent. With the September
quarter 2001 CPI figures, it is now possible to gauge the trend in prices over
a one-year period which is largely free of these effects. Over the four quarters
to the September quarter, the CPI rose by 2.5 per cent. This compares with
3.2 per cent for the year to June 2000, immediately prior to the GST's
introduction. The recent decline in petrol prices is the principal factor behind
the decline in CPI inflation between these two observations. In underlying
terms, inflation was closer to 3 per cent over the latest twelve months, up
slightly from 2½ per cent in the first half of 2000.

So it is now increasingly clear that the economy has weathered the substantial price
shocks which occurred last year – the GST, a substantial rise
in wholesale import prices due to the decline in the exchange rate, and the
rise in oil prices (since partly reversed) – without a significant deterioration
in ongoing inflation performance relative to the target of 2–3 per cent.
Inflation expectations, after an initial spike associated with the GST, have
declined again, wage claims have remained moderate, and competition in most
product markets remains keen, notwithstanding the demise of some firms which
had cut prices most aggressively in some areas.

At current levels of the exchange rate there should, all other things equal, still
be some upward pressure on prices for traded goods and services in the next
quarter or two. This factor, together with the impacts of higher insurance
premia, rises in air fares and increased electricity charges in some areas,
suggests that annual rates of underlying inflation slightly above 3 per cent
could still be observed in the near term, as profit margins are gradually restored.
These forces have a finite life, however, and given the apparent continued
moderate increase in labour costs, the pace of price increases can still be
expected to lessen somewhat in due course, as the price level for tradables
measured in Australian dollars reaches its new, higher long-term level and
other one-off factors fade. International developments, moreover, are placing
downward pressure on the foreign currency prices for tradables in international
markets. This in turn means that profit margins for importers might be restored
without as large a rise in the price to Australian consumers as would otherwise
have been the case.

The relatively good performance, by international standards, of the domestic economy
has been reflected in financial markets. Australian share prices remain only
a little below their peak, in contrast to the falls of 30 per cent or more
in many other countries. While domestic interest rates have fallen to historical
lows, they have not fallen as much as in some other countries. As such, interest
differentials have moved in the Australian dollar's favour. This and the
share market's resilience have in general supported the exchange rate.
On the other hand, with the international trading environment deteriorating,
there have been periods of weakness in the exchange rate, particularly after
the terrorist attacks in the US. The Bank thought it important to provide a
stabilising influence in these circumstances, and undertook foreign exchange
intervention to support the exchange rate in the month of September.

At its meeting on 4 September, the Board judged that the risks to the world economy
and signs that inflation would soon peak made it appropriate to ease monetary
policy further, notwithstanding the possibility that above-target inflation might be observed temporarily
in the near term. The cash rate was reduced by 25 basis points.

The immediate aftermath of the terrorist attacks on 11 September proved a testing
time for financial markets. In common with central banks in other major countries,
the Reserve Bank sought to ensure, through its daily operations, that uncertainty
and heightened risk aversion did not lead to settlement problems or systemic
failures in the Australian market. The Bank did not, however, see a case to
depart from its normal timetable for considering monetary policy as a result
of these developments. The key priority immediately following 11 September was to ensure that the financial
system remained functional. Apart from that, the direct short-term impact on
the Australian economy of the events themselves was not likely to be large,
and a considered response to any likely longer-term impacts was always advisable.
Hence the Board met at its normal time on 2 October and, assessing all the
available evidence about global events both pre and post the attacks, decided
on a further reduction in rates, bringing the cash rate to 4.5 per cent. By
any conventional measure, this represents an expansionary setting of monetary
policy, a conclusion which can only be reinforced by the low level of the effective
exchange rate. To be sure, Australian interest rates are now noticeably above
those in the US. But that reflects the contrast between the particular circumstances
of the US economy, to which the US authorities have needed to respond, and
the relatively stronger performance of the Australian economy since the start
of the year. It was with these factors in mind that, at its 6 November meeting,
the Board elected not to change the stance of policy for the present.

The period ahead is shaping up as a particularly testing time for the global economy
and Australia cannot hope to be unaffected by these events. But Australia can
reasonably hope to fare better than most other economies in the current episode.
Because exposure to the production side of the ‘new economy’ was
limited, a major contractionary force at work in the US and Asia is not affecting
Australia to the same extent. In fact, as an importer of high-tech manufactured
goods, Australia's terms of trade, and hence national income, are improved
by the decline in prices of a wide range of such goods. The Australian share
market had not been subject to the excesses seen in some overseas countries
in earlier years, and it is therefore not facing the same correction now. While
profits have declined somewhat, company balance sheets are in good shape and
the financial system is sound. Macroeconomic policies are exerting an expansionary
influence on output, and have scope to do so because inflation is well controlled
and public debt is low. These are the benefits afforded by consistently disciplined
policies in the past decade or more.

As always, the Bank continues to assess the available information and will adjust
as necessary the stance of policy in pursuit of sustainable growth, consistent
with the inflation target.

International Economic Developments

Global economic conditions have deteriorated through the year, with growth slowing
in all major regions (Table 1). While the main catalyst for the slowdown
came initially from the information technology and communications (ITC) sector,
which had underpinned growth in many countries in previous years, it became
more broad-based as the year progressed, with weaker production and investment
outcomes spreading across the industrial sectors of many countries. More recently,
and even prior to the terrorist attacks in the United States, consumer spending
also began to slow, partly reflecting softer labour market conditions. Unemployment
rates have stopped falling in most of Europe and are rising in North America
and most countries in Asia. While the slowing in output growth has been synchronised,
unlike the recession of the early 1990s, the policy response in a number of
countries has been relatively rapid.

Table 1: World Growth

Percentage change

Year to June 2000

Year to June 2001

United States

5.2

1.2

Euro area

3.9

1.7

Japan

1.0

−0.7

China(a)

8.2

7.9

Other Asia(b)

7.5

1.2

G7(b)

3.6

0.8

Australia's major trading partners(b)

4.0

1.1

(a) Six months to June over six months to June of previous year (b) GDP-weighted

Source: Datastream

An easing of inflationary concerns in most countries has enabled monetary policy
to be more accommodative, with the global slowdown putting downward pressure
on prices due to increases in spare capacity. Wages growth in most countries
remains contained. The recent fall in oil prices, if maintained, is also likely
to put downward pressure on inflation, though the possible effect of military
action places more than the usual degree of uncertainty around this.

The Americas

The US economy contracted for the first time since March 1993 in the September quarter
(Graph 1). The fall reflected a decline in business investment, which
fell for a third consecutive quarter and is nearly 7 per cent lower than a
year earlier (Table 2). Investment in ITC equipment has been particularly
weak over much of the past year, following a significant run-up through the
1990s. Private consumption, which has underpinned growth, increased only modestly
in the September quarter despite the boost to household income from the tax
rebates received in the middle of the year. A rundown in inventories subtracted
slightly from growth in the quarter, but has subtracted over a percentage point
from growth over the past year.

Graph 1

Table 2: United States National Accounts

Percentage change, seasonally adjusted

September quarter 2001

Year to:

September 2000

September 2001

Private consumption

0.3

4.9

2.5

Residential investment

0.4

−0.5

3.7

Business investment

−3.1

10.2

−6.7

Public demand

0.4

2.4

3.8

Change in stocks(a)

−0.1

0.1

−1.1

Net exports(a)

0.1

−0.9

0.2

– exports

−4.4

11.3

−8.7

– imports

−4.0

14.2

−7.4

GDP

−0.1

4.4

0.8

(a) Contribution to GDP growth

Source: Datastream

Manufacturing production fell by 1.7 per cent in the September quarter to be more
than 5 per cent lower than the peak recorded a year earlier (Graph 2).
Business confidence in the manufacturing sector, as measured by the NAPM index,
showed some signs of recovery in the September quarter but fell sharply in
October to levels last recorded in the early 1990s recession. Profits of non-financial
corporations have declined sharply over the past year, with profits as a share
of GDP falling back to around levels of the early 1990s. With firms facing
intense competition in a slowing market, investment plans are being curtailed
and the number of layoff announcements has increased.

Graph 2

Employment has continued to fall over the second half of 2001, with the unemployment
rate rising by nearly one percentage point over this period. The declines in
employment were broad-based: falls were recorded in the wholesale trade, services
and retail sectors, whereas previously the fall in employment had been concentrated
in the manufacturing industry. Measures of consumer sentiment deteriorated
from the middle of the year, with particularly large falls recorded in September.
These factors, together with a fall in equity prices, have worked to offset
the positive effect of increases in disposable income associated with the income
tax reductions in the middle of the year and the increase in mortgage refinancings
associated with lower long-term interest rates. In contrast to previous slowdowns,
the housing sector remains reasonably buoyant as mortgage interest rates were
already relatively low preceding the slowdown.

While it is difficult to quantify the impact of the terrorist attacks on the US economy,
they had an immediate effect on both consumer and business confidence. At this
stage, it is not clear to what extent the falls in business and consumer confidence
will translate into falls in aggregate demand, though the speedy policy responses
will be helpful. Immediate effects were also felt in a number of sectors where
supply was either severely disrupted directly (such as airlines and business
and financial services) or indirectly (such as retail and manufacturing). Higher
frequency data, such as initial jobless claims and weekly readings of consumer
confidence and retail sales, suggest that activity has recovered somewhat,
though it is still below levels recorded prior to the attacks.

Underlying inflation has remained stable with higher medical costs being offset by
falls in the price of electronic goods and motor vehicles (Graph 3). Wage
outcomes are drifting lower, though this has been offset to some extent by
an increase in benefits being paid. However, the outlook is for a decline in
inflation due to increases in spare capacity of both the labour and capital
markets, downward pressure on world prices and falls in the price of oil.

Graph 3

As signs of the slowdown have emerged, the US Federal Reserve has eased monetary
policy much faster than in the early 1990s recession with the Fed funds rate
now at its lowest level in almost 40 years. The Fed funds rate was cut by 50
basis points shortly after the attacks in an effort to reduce the likely negative
effect on business and household confidence of the terrorist attacks, and by
a further 100 basis points in subsequent months, bringing the cumulative easing
over the course of the year to 450 basis points. Using the underlying measure
of the CPI, the real Fed funds rate is below zero, a level previously reached
in the recessions of the early 1980s and 1990s.

Fiscal policy has also become supportive of growth due both to policy initiatives
and to the operation of the automatic stabilisers (Graph 4). The fiscal
package announced mid year amounted to about 1 per cent of GDP spread over
two years. Since then Congress has approved emergency relief and airline industry
assistance totalling US$55 billion (around ½ a per cent of GDP) spread
over the next two years and is considering a further US$100 billion package (equivalent to 1 per cent
of GDP).

Graph 4

The slowdown in the US has had a significant impact on its two closest neighbours,
Mexico and Canada. Growth in Canada has tracked that of the US fairly closely,
with year-ended growth in output falling from 5 per cent in March 2000 to just above 2 per cent in June 2001.
Much of the fall in growth is due to a decline in manufacturing production,
with the slowdown in the US likely to cause further weakness in the transport
and auto industries. Monetary and fiscal policies have both been eased, but
not to the same extent as in the US. Mexico experienced its third consecutive
decline in output in the June quarter, driven by falling investment and weaker
exports. As in Canada, the export-related industries (especially tourism and
oil) are likely to face lower revenues in the next few quarters.

The other Latin American countries are also experiencing weakness. Annual growth
in output in Brazil has fallen from a peak of around 6 per cent in the middle
of 2000, to around 1 per cent. The recent weakness reflects softer external
demand, though energy-rationing measures also reduced output in the June quarter.
Argentina's economy continues to contract, with year-ended growth in output
falling for the fourth consecutive quarter in June (for details on Argentinian
financial markets see ‘International and Foreign Exchange Markets’).

Asia-Pacific

Japan

The Japanese economy has deteriorated further with the national accounts showing
a decline in output in the June quarter. Real GDP has shown little growth over
the past four and a half years (Graph 5). Moderate growth in private consumption
in the quarter was more than offset by falls in private investment, driven
largely by the slowdown in global demand for ITC goods.

Graph 5

Indications are that the Japanese economy contracted further in the second half of
the year. Weakness in the ITC sector, which accounts for about 14 per cent
of industrial production, has persisted, with manufacturing output in that
sector almost 30 per cent below late-2000 levels and export volumes down by
a similar amount over the same period (Graph 6). However, weakness in
the manufacturing sector has become more broad-based, with non-ITC output down
to levels below those seen during the Asian crisis. Business sentiment, as
measured by the Tankan survey, declined further in the September quarter, in
response to deteriorating economic conditions and the potential fallout from
the terrorist attacks in the US, though the index is still above the levels
recorded in the Asian crisis and the early 1990s recession. The survey also
pointed to subdued capital expenditure plans.

Graph 6

The prospects for consumer spending have worsened. Employment has declined by around
1½ per cent since late 2000 with the unemployment rate reaching
an historic high of 5.3 per cent in September; job offers are also trending
downwards. Consumer prices continue to fall, with the core measure of inflation
around ¾ of a percentage point lower in September 2001 compared with
a year ago.

The Bank of Japan has responded to the deteriorating economic circumstances by implementing
measures to boost the level of settlement funds held by the banking system
as there is no scope for official interest rates to be reduced further. The
government has announced the outline of a fiscal package which includes employment
support measures and assistance for small business. A self-imposed limit on
bond issuance by the government has limited the size of the package. Senior
Bank of Japan and government officials have suggested that asset sales may
be used to fund any further increases in expenditure. In any case, the spending
is likely to be more modest than previous supplementary budgets and will therefore
do little more than maintain the support for activity currently in place.

Non-Japan Asia

Much of the region's exports have been affected significantly by the downturn
in global growth and demand for ITC goods. Exports of the four major ITC producers
– Korea, Taiwan, Singapore and Malaysia – were around 25 per cent lower in September than their peak
in 2000 (Graph 7). The sharp decline in exports over the past year has,
in turn, dampened production and investment, although production appeared to
be stabilising in the middle of the year, with solid increases in July and
August. In contrast, consumer spending, which had underpinned growth in most
countries over the first half of the year appears to be moderating, especially
in those countries experiencing rising unemployment (Taiwan, Singapore, Hong
Kong and Thailand). Korea has fared relatively better, due to ongoing strength
in domestic demand.

Graph 7

The slowdown in growth experienced in non-Japan Asia towards the end of last year
became more pronounced in the first half of 2001. GDP in the region (excluding
China) contracted by ½ per cent in the June quarter – the first
decline since the 1998 crisis – following two quarters in which it had
not grown. The weakness in growth has been most pronounced in those countries
heavily involved in the ITC sector. China remains the only economy in the region
to be growing at a robust pace, largely reflecting the relatively small size
of its external sector, the more diversified nature of its exports and expansionary
fiscal policies.

In response to the deteriorating outlook, monetary authorities in much of the region
have eased policy. Official interest rates have been reduced significantly
in Taiwan, while Korea has eased quite quickly as inflation has moderated.
In the Philippines, the sharp rise in interest rates last year in response
to rising inflation has largely been unwound. Hong Kong has reduced rates in
line with falls in US official interest rates, and Malaysia reduced rates in
the wake of the terrorist attacks in the United States (Table 3).

Table 3: East Asian Monetary Policy Responses

Change in monetary policy since late 2000
Basis points

Current policy rate
Per cent

Korea

−125

4.00

Taiwan

−250

2.25

Malaysia

−50

5.00

Hong Kong

−450

3.50

Thailand

+100

2.50

Philippines

−525

8.25

Source: National central banks

Several countries have also announced fiscal packages aimed at boosting domestic
demand. In Singapore, the government has announced two packages totalling 8.4
per cent of GDP, which is slightly larger than the stimulus implemented during
the Asian crisis. The Hong Kong, Malaysian and Korean governments have also
announced stimulus packages that are more modest in size than in Singapore.
The Hong Kong package includes measures to assist residential property owners
with negative equity in their property due to the significant fall in residential
property prices in recent years. In Taiwan, stimulus measures were announced
earlier in the year, but delays in legislative approval have meant that the
impact is more likely to be felt from the second half of this year.

New Zealand

The New Zealand economy grew by 2 per cent in the June quarter, following a period
of slow growth over the preceding year. Private investment rebounded in line
with firming business confidence, while consumer spending rose strongly reflecting
buoyant labour market conditions and rising rural incomes. Net exports continued
to make a strong contribution to growth, with a low exchange rate offering
some protection against the slowdown in world growth. Inflation declined to
2.4 per cent in the September quarter, having been around the top end of the
RBNZ's target range for the past year due to rising world oil prices, an
increase in taxes on tobacco and the depreciation of the exchange rate. The
RBNZ reduced the official cash rate by 50 basis points in September, bringing
the cumulative easing since March 2001 to 125 basis points.

Europe

Annual growth across the Euro area weakened to around 1¾ per cent in the middle
of the year, from its peak of just under 4 per cent a year earlier, though
the outcome in the UK was somewhat stronger than that recorded in continental
Europe, with this strength continuing in the September quarter. The slowing
across Europe was driven by falls in exports, particularly in France, Italy
and the UK. Business investment was also very weak in line with the falls recorded
in industrial production. In contrast, growth in consumption proved more resilient
across most countries, particularly in Germany (where income tax cuts appear
to have boosted consumer spending) and the UK, both of which had been subdued
late in 2000.

Manufacturing production showed some signs of stabilising across Europe in the middle
of the year, in line with a levelling out in business confidence. However business
sentiment has fallen sharply over the past couple of months. The survey results
may have been temporarily depressed following the terrorist attacks in the
US. However if the survey results are indicative of renewed weakness in Europe,
downward adjustments are likely to be made to investment plans and the pace
of corporate retrenchment will accelerate. The declines in production in Europe
earlier in the year appear already to be having an impact on employment growth,
especially in Germany, with nearly all countries recording weaker employment
outcomes over the course of this year (Graph 8).
One exception is the UK where the unemployment rate is around an historical low.

Graph 8

Inflationary pressures continue to ease in the euro area (Graph 9) with CPI
inflation falling from its recent peak of 3.4 per cent in May to 2.5 per cent
in September, as the impact of higher oil and food prices was unwound. When
food and energy are excluded, inflation has drifted higher, though this is
expected to be reversed in response to slower growth in aggregate demand and
the effect of the recent appreciation of the euro. The ECB eased monetary policy
by 25 basis points in late August, and by a further 50 basis points in mid
September. Consumer prices in the UK have risen over the past year due to higher
food prices in the wake of the foot and mouth disease problem. However, inflation
remains around the Bank of England's inflation target of 2½ percent.
The Bank of England also cut its key interest rate by 25 basis points to 4.75
per cent in mid September, citing concerns about world growth and the impact
of the terrorist attacks, and by a further 25 basis points in early October.
This brought the cumulative easing in the UK this cycle to 150 basis points.

Graph 9

The scope for discretionary fiscal policy to be eased across Europe in the year ahead
in response to weaker conditions is constrained by the European Union Growth
and Stability Pact, and the overall thrust of policy in 2002 is broadly neutral
(Table 4). While most countries are well within the 3 per cent deficit
ceiling that triggers penalties, the deficits are forecast to exceed the current
Stability Program targets which set down an adjustment path for achieving balanced
fiscal positions. In contrast, in the UK a mild fiscal easing is projected
next year, following an easing equivalent to around ¾ of a percentage
point of GDP this year.

World economic outlook

The outlook for world economic growth in 2001 has been continually revised down this
year, with significant revisions occurring before the terrorist attacks in
the US. Surveys of private-sector forecasters, which attempt to take these
events into account, imply world growth of around 2½ per cent in 2001
and around 3 per cent in 2002, well down on forecasts from three months ago
(Graph 10). The impact on the major industrialised countries is expected
to be greater and would take growth in both years to around that recorded in
1991. The impact on Australia's trading partners is also expected to be
pronounced, with the degree of synchronisation of the current global economic
slowdown having the potential to limit the scope for diversion of exports.

Graph 10

Macroeconomic policies are responding to this weakness. Central banks around the
world have eased monetary policy in an effort to support demand, with real
official interest rates in G7 countries now at their lowest level in over two
decades (Graph 11). Fiscal settings have also become more accommodative,
with major expansionary packages announced in the US and a number of Asian
countries. Based on IMF forecasts, fiscal settings in the major industrialised
countries have been broadly expansionary in 2001, Japan being the main exception.
Given recent fiscal packages announced in the US and Asia and the impact of
slower growth in government revenues due to weakening activity, it is likely
that fiscal policy will also be expansionary in 2002.

Graph 11

The current cyclical downturn is different from those of the past few decades, in
that monetary policy was not as tight prior to the downturn as in other episodes.
However the structural imbalances that exist in some countries are large. At
this stage, the most likely outcome for the major economies is that the recession
in the second half of this year is followed by a modest recovery towards the
middle of 2002. A faster recovery, which is characteristic of earlier cycles,
is a possibility although the size of the imbalances that need to be unwound
in the US, and the ongoing problems in Japan, suggest that this is unlikely.
On the downside, there is a risk that the synchronised slowdown, coupled with
heightened military tensions globally, will lead to a persistent fall in appetite
for risk among businesses and much more conservative behaviour by households.

International and Foreign Exchange Markets

Short-term interest rates

The process of monetary easing that has been evident in most industrial countries
during the past year has continued in recent months, as central banks responded
to growing signs of economic weakness and evidence that inflationary pressures
are starting to diminish.

Central banks around the world acted quickly after the terrorist attacks to boost
liquidity in their financial systems. The aim was to ensure that markets did
not experience systemic failures resulting from disruptions in payments and
settlements systems or the increase in risk aversion. To help calm markets,
many central banks issued statements immediately after the attacks, outlining
their intentions to provide liquidity support to their financial institutions.
These measures were designed to ensure the continued smooth operation of markets
rather than to change monetary conditions. The easings by central banks in
September generally did not start until a week or so after the attacks. (Australia
was an exception in that it had reduced interest rates in early September.)

On 17 September prior to the re-opening of US share markets (markets were closed
for 4 working days – the longest shutdown since the 1930s) the US Federal
Reserve announced a cut of 50 basis points in its official interest rates.
It was followed over the next 48 hours by several other central banks. Subsequent
to these steps, which in most instances occurred outside the central banks'
regular policy schedules, many central banks followed up with further cuts
in interest rates at their regular policy meetings (Graph 12).

Graph 12

The US Federal Reserve has cut interest rates at every policy meeting this year,
as well as on three occasions between meetings. In total, there have been 10
cuts in rates, amounting to 450 basis points. These have reduced the Fed funds
target to 2.0 per cent, its lowest level since the early 1960s and 100 basis
points below the low point seen in the early 1990s recession (Graph 13).
Real short-term interest rates in the US are now around the lows seen in the
early 1990s (Graph 14). Financial markets continue to price-in further
rate reductions in the US over coming months. They expect the Fed funds target
will fall to 1.75 per cent or lower.

Graph 13

Graph 14

Cumulative easings by other central banks have been significantly less than those
of the US Fed. After the Fed, the largest easing has been by the Bank of Canada,
which has reduced rates by 300 basis points in 2001. This includes a cut of
75 basis points on 23 October, which took the target cash rate to 2.75 per
cent (Table 5).

Table 5: Policy Interest Rate Changes

Basis points

2001

Cumulative changes since Jan 2001

Current level
Per cent

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

US

−100

−50

−50

−50

−25

−25

−50

−50

−50

−450

2.00

Canada

−25

−50

−25

−25

−25

−25

−50

−75

−300

2.75

Australia

−50

−25

−50

−25

−25

−175

4.50

UK

−25

−25

−25

−25

−25

−25

−150

4.50

NZ

−25

−25

−25

−50

−125

5.25

Switzerland

−25

−100

−125

2.25

Euro area

−25

−25

−50

−100

3.75

Japan

−10

−15

−25

0.00

Sources: Central banks

The cumulative cuts this year by other central banks (excluding Japan) generally
range from 100 to 175 basis points, with Australia at the top end of this range
and the European Central Bank (ECB) at the lower end.

The current level of interest rates among industrial countries (leaving aside Japan
where interest rates are at zero) ranges from 2.0 per cent in the US to 5.25
per cent in New Zealand. By historical standards, this range is both low and
narrow (Graph 15). Among the English-speaking countries, nominal rates
are generally at their lowest level for about 30 years. In Europe, while interest
rates are low, they remain above the levels prevailing during the period of
economic weakness in the late 1990s. The low level and relatively narrow range
of interest rates around the world reflects the fact that inflation is also
in a tight range, and low by historical standards.

Graph 15

Having reduced its interest rates to zero in March 2001, the Bank of Japan has since
been directing its monetary policy to boosting banks' total reserves. Initially
the target for reserves was set at 5 trillion yen, which was around 20 per
cent above average reserve holdings over the previous year. It has since been
increased to ‘over 6 trillion’ yen. Actual reserves rose above
this for a time in the second half of September as banks sought to boost their
liquidity ahead of their half-year balance date, and are currently at around
9 trillion yen. The Bank of Japan supplied the additional reserves ahead of
end September partly by not sterilising intervention that it was undertaking
in the foreign exchange market at that time. In other words, it allowed the
yen that it delivered to banks in exchange for its purchases of US dollars
to remain in the money market, rather than withdraw them by the sales of securities.

Asian central banks, with the exception of Bank Indonesia and Bank Negara, also have
eased monetary policy over the past few months. In these countries, nominal
interest rates are at low levels, generally in the range of 1–4 per cent. This is well below the level
of rates that followed the Asian financial crisis. Indonesia has not shared
in this downward trend in interest rates; its rates have been rising since
mid 2000 and are now about 18 per cent(Graph 16).
This difference is largely explained by the much higher inflation rate in Indonesia,
which over the past year was 13 per cent.

Graph 16

Interest rates in Latin America remain high due to concerns about the sustainability
of Argentinean finances, despite further IMF support. Short-term peso interest
rates in Argentina are around 60 per cent at present, substantially higher
than their level at the time of the 1998 financial crisis. In Brazil, they
are around 20 per cent, or about half their 1998 levels (Graph 17).

Graph 17

Long-term interest rates

Long bond yields around the world have generally continued to fall over recent months.
Lower official interest rates, downward revisions to growth prospects in virtually
all countries and signs that inflation in most countries was receding were
the main forces driving this. The terrorist attacks added to the downward pressure,
particularly for government yields as investors sought to move into relatively
safe investments. The fall in bond yields was most notable in the US, where
10-year US Treasury bond yields are down about 125 basis points from their
level six months ago and 250 basis points from their peak in early 2000. Yields
have fallen to 4.20 per cent, and intra-day fell to 4.1 per cent, the lowest
level of bond yields since the mid 1960s (Graph 18).

Graph 18

Long yields in the US have not fallen as much as short rates this year, and are currently
over 200 basis points above short rates (Graph 19). This gap is quite
high by historical standards, indicating that monetary conditions in the US
are relatively easy at present. The gap is not as wide as in the early 1990s,
however, suggesting that, on this measure, monetary conditions are not as easy
as in that earlier period.

Graph 19

The spreads between yields on government bonds and those on corporate bonds in the
US were relatively steady over August and the first part of September, but
rose noticeably after the 11 September terrorist attacks. This was because
uncertainty created by those attacks led to a rise in risk aversion among investors
and therefore a preference for government debt. The increase in spreads was
most significant on riskier classes of fixed income debt; spreads on high quality
AAA-rated paper did not react much.

Despite the recent rise, the current level of spreads for all the credit categories
remains within the range of the past couple of years (Graph 20). That
is, markets are not pricing-in an unusually severe deterioration in credit
quality.

Graph 20

In European bond markets, yields have continued to take their lead from the US. However,
while the direction of moves in Europe has mirrored the US, the amplitude has
generally been less. German 10-year government bond yields have fallen by around
90 basis points over recent months, to 4.30 per cent. Consequently, the relativities
between US and German 10-year government bonds changed sharply. Six months
ago, US yields were about 30 basis points above German yields but recently
they have generally been below.

Yields on Japanese government bonds have tracked an independent course over recent
months, with yields on 10-year government paper generally trading in a tight
range between 1.30 per cent and 1.40 per cent.

In emerging markets, the focus remains on Argentina, where economic and financial
conditions have failed to improve over the past three months. Although additional
IMF assistance was forthcoming in August, investor concerns about the ability
of the Argentine Government to meet debt obligations have remained. These concerns
were exacerbated in early November when the government announced a plan to
swap outstanding government debt with bonds yielding lower coupons. Although
ostensibly ‘voluntary’, the swap plan has been interpreted by many
in the financial markets as tantamount to default, with Standard and Poor's
revising Argentina's sovereign credit rating down to ‘Selective Default’
from CC. Spreads between the country's sovereign debt and US Treasuries
increased sharply on the announcement, by 400 basis points to over 2,400 basis
points (Graph 21). The current level of spreads is higher than that reached
in the mid-1990s crisis. Although events in Argentina have contributed to further
rises in yields throughout Latin America, as well as in European emerging markets,
the increases so far appear to be reasonably well contained. Spreads on Asian
sovereign debt have remained remarkably stable despite events in Argentina.

Graph 21

Equity markets

The significant deterioration in the global economic outlook and continued disappointing
earnings announcements, particularly by technology companies, have weighed
heavily on equity markets over recent months. This equity market weakness mostly
predated the terrorist attacks, with August being a particularly weak month
in most countries. The terrorist attacks initially led to a further sharp fall
in share prices, but by early October this had been unwound in most countries
(Graph 22).

Graph 22

In the United States, the Wilshire Index, the broadest measure of US share prices
(accounting for over 90 per cent of listed companies) has fallen by
9 per cent since early August and is now 30 per cent below the peak in March
2000. The S&P 500 has experienced similar falls, while the Nasdaq is down
12 per cent since early August, and 64 per cent from its early 2000 historical
high. Since early 1995, when the last phase of the bull run in shares began,
the Wilshire, S&P 500 and Nasdaq are now all showing similar net increases
– about 120 per cent(Graph 23).
The marked outperformance of the Nasdaq during 1999 and early 2000 has now been fully
reversed. It is hard to avoid the conclusion that the Nasdaq index experienced
a major bubble over this period, rising by 150 per cent over the 15 months
to March 2000, only to reverse this over the following twelve months
or so.

Graph 23

Earnings of companies in the US continue to be weak. For those companies in the S&P
500, earnings declined by 34 per cent in the year to September. The fall in
earnings over 2001 is likely to significantly exceed the 15 per cent fall seen in 1991, the worst year
for earnings in the early 1990s recession.

Despite the substantial falls in share prices since the early 2000 peaks, some traditional
measures of share price valuation, such as price-earnings (P/E) ratios, remain
relatively high. The current P/E ratio for the S&P 500, of around 29, remains
well above its historical average of 16, even though it is down from the recent
peak of 36 (Graph 24).
Likewise, the ratio of US share market capitalisation to nominal GDP remains well
above its historical average (Graph 25). For this to be justified would
require either that GDP in the future grow substantially faster than its historical
average, or at least that the share of GDP going to company profits be higher
than its historical average.

Graph 24

Graph 25

Share prices in other countries have generally followed those in the US, although
in many cases falls have been even more pronounced than in the broad US markets
(Table 6). The Euro Stoxx index (a broad index of 310 major Euro area
companies) has fallen by 12 per cent since early August, and at one stage in
late September was down by over double that amount. European markets tend to
have quite a high exposure to the telco sector, which has been a particularly
weak sector around the world.

Table 6: Changes in Major Country Share Prices

Per cent

Change since 2000 peak

Change over 2001

Change over past six months

United States

– Wilshire

−30

−16

−12

– Dow Jones

−19

−11

−13

– S&P 500

−27

−15

−12

– NASDAQ

−64

−26

−15

Euro area

– STOXX

−36

−23

−18

United Kingdom

– FTSE

−25

−16

−11

Japan

– TOPIX

−41

−19

−28

Australia*

– ASX 200

−6

1

−3

Canada

– TSE 300

−37

−20

−11

* Peak was in 2001

Source: Bloomberg

The pattern in the Japanese share market over recent months has been similar to that
in other major countries. The level is, however, much lower. Share price indices
in Japan are around one third their level at the peak in 1990.

Asian equity markets have resumed their downward trend, after a brief period of stability
around the middle of the year (Graph 26). In aggregate, Asian equity markets
(excluding Japan and China) have fallen by around 24 per cent
so far this year, but individual performance continues to vary. Hong Kong, Singapore
and the Philippines have each fallen by around 30 per cent, while Korea has
gained around 10 per cent on levels at the start of this year. Share prices
in Latin America are also down by 12 per cent this year (Graph 27). They
have been particularly weak in Argentina, where price falls since the start
of the year have been in the order of 40 per cent.

Graph 26

Graph 27

Exchange rates

The strong US dollar appreciation evident since 1995 was partly reversed around the
middle of 2001 as the factors that supported the US dollar over the latter
half of the 1990s disappeared. The interest rate differential with the rest
of the world, for a long time positive to the US, turned negative against most
major countries. Similarly, the growth gap in favour of the US closed and US
productivity growth slowed (with historical data also having been revised weaker).
Falls in the share market also reduced the attractiveness of US equities.

The events of 11 September initially caused the US dollar to fall further (Graph 28).
The largest fall was against the Swiss franc, which rose due to increased ‘safe-haven’
flows following the terrorist attacks. The Swiss authorities expressed concern
about the franc's appreciation (it rose by 7 per cent against the US dollar
and 5 per cent
against the euro following the terrorist attacks) and cut interest rates by 50 basis
points in response. The US dollar also fell noticeably against the yen. There
were reports of repatriation of overseas investments by Japanese institutions
to reduce their foreign exposures ahead of their September half-year end. The
decline against the yen was resisted by significant intervention in the foreign
exchange market by the Japanese authorities, who have repeatedly asserted that
an appreciating yen is not consistent with the country's fundamentals.
Swings in the US dollar/euro exchange rate have been more muted, though the
euro remains at a relatively low level.

Graph 28

More recently demand in the foreign exchange market has again swung in favour of
the US dollar. Investors seem to be of the view that the significant monetary
and fiscal stimulus applied in the US since the September attacks will result
in US economic activity recovering faster than in Europe (and Japan). The recent
renewed strength of the US dollar means that its trade-weighted value is now
only about 2 per cent below its July peak (Table 7).

Table 7: Changes in the US Dollar Against Major Currencies

Per cent

Change over 2001

Change since July peak

TWI

5.2

−2.2

Euro

5.0

−6.8

Yen

5.8

−3.8

Source: Bloomberg

Currencies of Asian emerging markets that float appreciated against the US dollar
in July and August, but have since depreciated leaving them relatively unchanged
(Graph 29). The exception is Indonesia, where the rupiah has appreciated
by 7 per cent since July after resolution of uncertainties regarding the country's
political leadership. Latin American currencies continued to slide due to contagion
from problems in Argentina. The Brazilian real is down 24 per cent for this
year, and the Chilean peso is down 18 per cent.

Graph 29

Australian dollar

After trading steadily around US51–52 cents during the middle months of 2001,
the Australian dollar has shown considerable volatility since (Graph 30).
It rose noticeably in August, to reach almost US54 cents. A number of factors
contributed to this, including a growing recognition among market participants
that the Australian economy was performing more strongly than its US counterpart.
Consensus forecasts for economic growth in Australia were holding up reasonably
well, while US growth forecasts were being revised down sharply. This pattern
was reflected in divergent trends in share markets in the two countries, with
the Australian market remaining close to its peak while the US market was falling
quite rapidly. Interest rate differentials were also moving increasingly in
Australia's favour. In addition, the release of the June quarter balance
of payments, indicating that Australia's current account deficit, as a
proportion of GDP, had fallen to its lowest level since 1980, further boosted
confidence in the currency.

Graph 30

Over late August and early September, as markets became increasingly concerned about
the impact of the weakening global economy on Australia, the exchange rate
of the Australian dollar began to fall. A weakening in the world economy has
traditionally been seen by markets as a negative factor for the Australian
dollar because, in the past, periods of global economic weakness have typically
resulted in falls in commodity prices and in Australia's terms of trade,
with consequential adverse effects on the balance of payments and the economy
more generally. As noted in the chapter on the ‘Balance
of Payments’, however, even though
world economic activity has slowed over the past year and commodity prices
have fallen, Australia's terms of trade have risen. This break from the
traditional relationship, if sustained, should in due course result in the
Australian dollar becoming more resilient to weakness in global economic growth.

The terrorist attacks in the US initially saw the Australian dollar rise amid a general
movement away from US dollar denominated assets. But the situation changed
quickly over subsequent days as risk aversion among international investors
increased. The Australian currency fell sharply, not only against the US dollar
but also against other major currencies. During this period, the pattern of
investment flows seemed to indicate both a retreat by international investors
to their home country and, within countries, a move from equities to relatively
secure investments such as government bonds. The currencies that did best during
this period were those of countries that have large creditor positions, such
as the Swiss franc and the Japanese yen.

Adding to the downward pressure on the exchange rate in the first half of September
was a number of large, one-off corporate transactions which resulted in substantial
sales of Australian dollars. Some of these hit the market immediately following
the terrorist attacks and their timing partly explains the unusually sharp
fall experienced by the Australian dollar during this period.

The Australian dollar reached a new low in trade-weighted terms of 46.0 in mid September;
the previous low had been 47.1, reached in early April this year (Graph 31).
Against the US dollar the exchange rate remained above its previous low of
US47.75 cents.

Graph 31

By late September, as confidence started to re-emerge in markets, and with the large
one-off transactions completed, the exchange rate stabilised and then recovered.
The recovery was reinforced as market attention focused on the widening interest
differential in favour of the Australian dollar.

Abstracting from the substantial volatility in the exchange rate over recent months,
the current levels of both the US dollar rate and the trade-weighted index
are broadly in line with the respective averages over the past year.

In view of the volatile conditions, the Bank undertook an increased amount of intervention
in the foreign exchange market in September, buying in total about A$780 million
in the market. Intervention operations in August and October were negligible.

Domestic Economic Activity

The Australian economy has recorded moderate growth during 2001, although it remains
somewhat slower than was recorded during the second half of the 1990s. Output
expanded at an annualised rate of 3¼ per cent over the first half of
this year, following the GST-related decline in the second half of 2000 (Graph 32).
The main reason for the resumption of growth was that dwelling investment stopped
falling (Table 8). A pick-up in growth of consumer spending and public
demand also contributed, and exports continued to rise strongly. A similar
pattern in growth was recorded across the states, with the pick-up in activity
in the first half of 2001 being most marked in Queensland and Victoria.

Graph 32

Table 8: National Accounts

Percentage change

Six months to:

June quarter 2001

December quarter 2000

June quarter 2001

Private final demand(a)

−2.4

2.1

0.2

Consumption

0.8

2.6

0.7

Dwelling investment

−31.2

3.2

3.6

Business investment(a)

−1.5

−2.0

−4.9

Public final demand(a)

0.4

2.1

0.9

Domestic final demand

−1.8

2.1

0.3

Change in inventories(b)

1.0

−0.9

0.7

Exports

2.2

2.0

1.1

Imports

−2.7

−2.4

−0.2

Net exports(b)

1.1

0.9

0.3

Gross domestic product

−0.2

1.6

0.9

(a) Adjusted for transfers between the public and private sectors (b) Contribution to GDP growth

Source: ABS

The significant expansion in the housing sector that is currently in train should
continue through much of this financial year, and will have flow-on effects
to construction-related sectors. While the confidence of the household sector
was adversely affected by the events of mid September, up until that time consumer
confidence had been reasonably positive, supported by the ongoing growth in
household incomes and assets and the reductions in interest rates since the
beginning of the year. Continued strong growth in household credit should provide
support for consumer spending in the period ahead.

Across the business sector, however, conditions have varied considerably over the
year to date. Conditions in the construction sector and the construction-related
parts of the manufacturing sector have clearly improved since the beginning
of this year, and the low exchange rate has afforded a competitive advantage
to export-oriented sectors. In contrast, conditions in parts of the services
sector, particularly those that are information technology and communications
(ITC) related, have deteriorated in line with global trends. Overall, the weakening
in trading conditions since the middle of 2000, combined with some increases
in costs, has contributed to a decline in aggregate measures of profitability.
Although businesses generally recorded some improvement in conditions around
the middle of the year, supported by easier fiscal and monetary policies, a
corresponding improvement in investment intentions and employment was not observed.
Businesses' external fund raisings, particularly through intermediaries,
have also remained subdued. More recently, the worsening outlook for the world
economy and uncertainty created by the events of mid September have increased
the risks surrounding the outlook, particularly for export-oriented businesses.

Household consumption

Consumer spending increased strongly in the first half of 2001, following subdued
growth in the second half of last year (Graph 33).
Spending on services (which accounts for around three-quarters of household consumption)
has continued to grow very strongly, driven largely by rising expenditure on
healthcare. Retail trade data suggest that robust growth continued in the September
quarter, with the volume of retail sales increasing by 1.6 per cent, to be
5.8 per cent higher than a year earlier. Over the past few quarters, the strength
in retail sales has been concentrated in hospitality and services, household
goods and other retailing (particularly sales of pharmaceuticals). The pick-up
in sales from household goods retailers has been consistent with the recovery
of the dwelling construction sector. Households' purchases of motor vehicles
have remained soft since the beginning of this financial year, in part reflecting
the unwinding of the pre-GST growth in motor vehicle purchases.

Graph 33

Some of the recent strength in consumer spending has been underpinned by one-off
factors. Consumer spending on healthcare has increased markedly over the past
year; it increased by almost 25 per cent over the year to the June quarter
and contributed around 1 percentage point to consumption growth over that period.
In part, this appears to have been a consequence of the government's ‘Lifetime
Health Cover’ initiative, which commenced on 1 July 2000. This initiative
encouraged the take-up of private health insurance and it seems that the increased
insurance cover has led to a significant increase in demand for health services
(Graph 34). The disproportionate growth of consumer spending on healthcare
relative to health services output in part reflects the large increase in spending
on pharmaceuticals during this period. The $300 payment to aged pensioners
in June, which was announced in the most recent Commonwealth budget, is also
likely to have increased spending on a range of retail items in recent months;
with more than 2.2 million people eligible for this payment, it amounts to
a potential stimulus of over $660 million.

Graph 34

More generally, however, continued growth in household incomes, reductions in interest
rates, lower petrol prices and modest growth in household assets have provided
conditions conducive to the ongoing expansion in consumer spending. Real disposable
income grew by 1.1 per cent in the June quarter, to be 3.7 per cent higher
over the year. Although labour market conditions were relatively weak in the
June quarter, this was offset by continued growth in wages and lower debt-servicing
payments. The fall in the latter, stemming from the lowering of interest rates
in the first half of the year, boosted household disposable income by around
½ of one percentage point in the June quarter. The growth in real disposable
income over the past year also reflects the fact that, in aggregate, the lowering
of tax rates and increases in transfer payments from July 2000 more than offset
the increases in prices that occurred at that time (Graph 35).

Graph 35

The sharp fall in interest payments has led to a substantially lower household debt-servicing
burden, although higher overall levels of household indebtedness mean that
the debt-servicing burden is well above previous low points (Graph 36).
Housing loan arrears, a lagging indicator of financial stress, remain a small
share of total loans by historical standards. The measured saving ratio is
currently above the average levels recorded in 1998 and 1999.

Graph 36

Household credit has grown by an annualised 17 per cent over the six months to September.
The strength in household borrowing reflects a significant further expansion
in both housing and personal credit, and should support consumption expenditure
in the presence of subdued employment growth. The household debt to disposable
income ratio has remained at its historical peak of 105 per cent.

On the other side of the balance sheet, the value of household assets increased by
3.7 per cent over the year to the June quarter, with robust growth being recorded
in the first half of 2001 after somewhat subdued growth in the second half
of 2000 (Table 9). In recent quarters, broad-based gains in dwelling prices
and further increases in household financial assets, owing mainly to strong
increases in holdings of equities, have contributed to this growth. The decline
in equity markets since the middle of the year, however, will have reduced
the value of households' financial assets.

Table 9: Household Assets

Level
$b

Annualised growth

Year to June 2001

Average 1996–99

Per cent

Non-financial assets

1,895

1.4

12.1

– Dwellings

1,726

1.0

13.0

– Consumer durables

168

6.0

4.3

Financial assets

1,248

7.3

11.0

– Currency and deposits

273

9.9

5.6

– Equities and unit trusts

274

16.8

25.1

– Superannuation and life offices

634

3.9

10.2

– Other

67

−4.1

6.4

Total assets

3,143

3.7

11.7

Source: RBA

Measures of consumer sentiment have broadly reflected developments in households'
incomes and assets. In the June and September quarters, consumer sentiment,
according to the Westpac-Melbourne Institute measure, was at a relatively high
level, consistent with the reasonable pace of consumer spending that was recorded.
In October, however, in the wake of the terrorist attacks in the US, the deterioration
in global growth prospects and the handover of Ansett airlines to administrators,
consumer sentiment fell sharply (Graph 37). While large, the fall in sentiment
was not unprecedented, being slightly less than the fall in March following
the release of the December quarter national accounts. Much of the weakness
in October was related to perceptions about economic conditions over the coming
year, rather than concerns relating to personal finances. Despite these falls,
consumer sentiment remains around its long-run average level.

Graph 37

Housing

Dwelling investment rose modestly in the first half of this year and the leading
indicators suggest that considerably stronger growth is in prospect for the
second half of the year. Early in the September quarter, both building approvals
and loan approvals for new construction almost regained the peak levels recorded
in early 2000 before easing a little in the latest monthly readings (Graph 38).
The growth in dwelling investment over the first half of 2001 was concentrated
in alterations and additions, and it appears that the recovery in house-building
activity was delayed to some extent by the collapse of HIH Insurance. While
liaison suggests that in most states the insurance-related delays have been
resolved, some problems appear to have persisted in NSW.

Graph 38

Over the past couple of years, the cycle in dwelling construction activity has been
significantly affected by government policies as well as the standard factors
such as interest rates and affordability. The effect of the introduction of
the GST in mid 2000 on dwelling construction activity has been discussed in
previous Statements. More recently, the introduction of the First Home Owner
Grant (FHOG) scheme and the Commonwealth Additional Grant (CAG) has assisted
the entry of some first-home buyers into the market earlier than would have
otherwise been the case. Given that the CAG was expected to expire at the end
of December (and the recently announced extension of the CAG still implies
some scaling back of the Grant from the beginning of 2002), it may also shift
some activity into the next couple of quarters from later periods. Information
collected by State Revenue Offices indicates a continued high level of grants
issued, particularly for new housing (Graph 39).
The effect of the government grants is also evident in the increase in the proportion
of first-home buyers seeking finance for housing. While first-home buyers generally
comprise around 25 per cent of loan approvals (excluding refinancing), the
latest figures put their share around 30 per cent. The gap between these figures
is suggestive of the additional stimulus that the government grants are having
on the housing sector. The FHOG has provided stimulus to housing demand in
all states, although its effect continues to be relatively large in the smaller
states, where median house prices are lower.

Graph 39

While the effect of the government grants on housing investment is likely to be significant,
the recovery in house purchases – both new and established – by
non-first-home buyers and investors has also been robust. Since the trough
in loan approvals to owner-occupiers in February, the number of loan approvals
for first-home buyers has increased by around 60 per cent, while loan approvals
to other owner-occupiers increased by around 30 per cent. Investor activity
has also been particularly strong: in value terms, the growth in demand for
housing loans by investors has been broadly similar to that of first-home buyers,
suggesting that other factors, notably low interest rates, have also been important
in the recovery. Part of the recovery in activity reflected a return to levels
consistent with underlying demand in the housing sector. The pick-up has been
stronger than this, however, and the current level of building approvals is
well above most estimates of underlying demand.

Strong demand for housing has been reflected in an 8 per cent increase in house prices
over the year to the June quarter 2001, according to stratified data published
by the ABS (Graph 40). These data attempt to remove the effect of compositional
change in the sample of houses sold; this has been important in aiding interpretation
of price movements in recent quarters, given the significant changes in the
proportion of first-home buyers in the market. House prices have increased
most strongly in recent quarters in Melbourne and Canberra, although increases
have been recorded in most capital cities. The Real Estate Institute of Australia
(REIA), which reports median house prices, indicates similar results to the
ABS for Australia-wide house price movements. However, in contrast to the rise
in house prices in Sydney in the June quarter reported by the ABS, REIA reported
a fall, which partly reflected an increase in the proportion of lower-priced
properties, particularly in the outer suburbs, which were purchased in the
quarter. Large price increases were recorded in the inner suburbs of Sydney.
There is now, however, mounting evidence that rental vacancy rates are rising,
particularly for medium-density dwellings, so the relatively strong growth
in medium-density construction in recent years may well be in the process of
lessening excess demand pressures.

Graph 40

The business sector

Output growth has continued to vary considerably across industries. After the sharp
slowdown in the second half of 2000, modest improvements in activity in the
construction sector occurred in the first half of 2001 (Graph 41). This
has already been associated with an increase in manufacturing output, consistent
with the close relationship between construction and related manufacturing
industries. Other traditionally cyclical sectors, such as the transport and
storage and retail and wholesale trade sectors, also recorded a strong increase
in output in the June quarter, with the inventory overhang that accumulated
during the second half of 2000 having been unwound to some extent. Some business-related
service industries, however, which had been growing relatively strongly in
recent years, reported a slowdown in growth in the June quarter. Part of the
earlier growth was a result of preparations for the Olympics, Y2K and the new
tax system, but the downturn has been exacerbated by the recent downturn in
the global ITC industry. (See Box A on ‘The Service Sectors’.)

Graph 41

Overall, businesses reported an improvement in conditions and confidence in the September
quarter, prior to the events of mid September. A strong improvement in business
conditions was reported in the September quarter NAB business survey, taking
the index above its long-run average level, with the improvement being concentrated
in domestically oriented industries, particularly construction, retail and
wholesale (Graph 42). The NAB and Yellow Pages surveys suggest that the
improvements were spread across small and large businesses. While the ACCI-Westpac
survey and other surveys that focus on the manufacturing sector reported that
actual conditions remained relatively subdued in the September quarter, they
did record a strong rise in business confidence for the next three to six months.
In contrast to the results for the domestically oriented sectors, the September
quarter NAB survey reported a deterioration in conditions for businesses exposed
to the international economy, particularly mining. This suggests that slowing
world economic growth was beginning to have an effect prior to the terrorist
attacks in the US.

Graph 42

Not surprisingly, surveys conducted after mid September have reported a marked deterioration
in business confidence. The September NAB monthly survey reported a large fall
in business confidence, taking the series to its lowest level since its inception
in 1997, and below all quarterly readings for this survey since 1991. All sectors
reported a fall in confidence, with particularly sharp falls recorded for those
sectors incorporating insurance and tourism, reflecting their greater exposure
to recent events. The September readings from the Dun & Bradstreet survey
and the ACCI Survey of Investor Confidence show similar effects. To infer strong
implications from this recent deterioration in sentiment for activity would
be premature, as it is unclear whether it will be sustained and, if it is,
how it will affect business decisions. In particular, it remains unclear whether
firms feel more confident about their own operations than about the national
economy, which, if true, could have a mitigating effect on business decisions.
This occurred during the Asian crisis and there is some evidence in recent
survey responses from the ACCI Survey of Investor Confidence that this may
be occurring in the current episode. Prospects for the tourism industry, however,
have clearly been adversely affected by these developments. (See Box B on ‘The Tourism Industry’.)

Even prior to mid September, the recorded improvements in business conditions and
confidence had not had an appreciable effect on businesses' investment
intentions, suggesting an underlying degree of caution within the business
sector. These results were consistent with the weakness in business investment
that continued into the June quarter. In aggregate, investment fell by nearly
5 per cent in the quarter, with a sharp 9 per cent fall in expenditure on machinery
and equipment more than offsetting a modest rise in non-dwelling construction
activity. Both components of investment have been very subdued over the past
couple of years, and are now well below long-run average shares of GDP (Graph 43).

Graph 43

According to the June quarter ABS capital expenditure survey, the outlook for machinery
and equipment investment for the 2001/02 financial year has also weakened.
These data now imply that nominal growth in equipment investment in 2001/02
will be below 3 per cent, assuming five-year average realisation ratios. Given
the recent further slowing in world growth and heightened levels of uncertainty,
however, it is likely that a lower realisation ratio is more appropriate. Much
of the expected growth in equipment investment continues to be concentrated
in the mining sector, which has been partially insulated from the deterioration
in global conditions by the low value of the Australian dollar. Investment
in motor vehicles, which represents around a quarter of overall machinery and
equipment investment, has, to date, received only a small boost as a result
of the recently announced changes to the tax treatment of business purchases
of motor vehicles.

Investment in buildings and structures is starting to recover, rising by nearly 2
per cent in the June quarter, largely due to an increase in engineering construction.
Following considerable weakness in the 2000/01 financial year, the outlook
for expenditure on buildings and structures has improved. The strong growth
in non-residential building approvals early in 2001, and the improvement in
other forward-looking indicators, such as commencements and work-yet-to-be-done,
points to a pick-up in non-residential construction activity in the quarters
ahead. Support for such activity has been provided by vacancy rates in office
property, which remain low by historical standards, and market valuations of
property trusts, which have continued to rise. The ABS capital expenditure
survey, which reported a strong rise in expected investment in buildings and
structures for 2001/02, and the improvement in the value of projects currently
under construction or committed, as reported in the Access Economics Investment Monitor, also point to an improvement in the outlook for
investment in buildings and structures. A considerable proportion of this growth
is expected to come from mining-related sectors.

The slowdown in expenditure on intangible fixed assets has continued, with overall
investment declining slightly in the June quarter. The main driver of the decline
was further weakness in expenditure on computer software (which accounts for
around 80 per cent of intangible fixed asset investment); demand for computer
software continues to slow in the post-‘tech boom’ environment
and following the boost provided by Y2K and the pre-GST spending on computing
and accounting systems. Mineral and petroleum exploration fell in the June
quarter, although it remains higher over the year and is expected to be strong
over the next six months, reflecting the highly competitive position of the
mining sector.

Subdued profits, reflecting increased cost pressures, high levels of competition,
and weaker trading conditions, are likely to have contributed to the weakness
in business investment. Corporate sector profits, as measured in the national
accounts, have fallen significantly since mid 2000 and fell by a further 4.2
per cent in the June quarter (Graph 44). Combined with revisions to recent
history, which suggest that corporate profitability was not quite as strong
as previously thought, these falls imply that corporate profits as a share
of GDP have fallen slightly below their average for the past decade.

Graph 44

Mining profits increased by around 14 per cent over the year to the June quarter,
driven by both strong output growth and higher commodity prices in Australian
dollar terms. In contrast, manufacturing profits have fallen by close to 20
per cent, but some recovery may be expected with the recent and prospective
strength in the housing sector. The recovery in the housing sector should also
be positive for profits of the small business sector, which – as measured
by the gross operating surplus (GOS) of unincorporated enterprises –
grew by just under 2 per cent in the June quarter, but remained slightly
below the level prevailing a year earlier.

The financial position of businesses, however, generally remains sound (Graph 45).
Lower official interest rates have contributed to the corporate net interest
burden falling in the June quarter, to be 21 per cent of GOS, which is quite
low by historical standards. The debt to equity ratio also fell in the June
quarter. Although loan arrears are increasing, associated with difficult trading
conditions, they remain at low levels as a share of credit.

Graph 45

Consistent with the weakness in business investment and businesses' generally
subdued assessment of current conditions, business borrowing from intermediaries
has been particularly weak, falling by around 1 per cent over the six months
to September on an annualised basis (Graph 46). Bank data suggest that
the slowing in business credit over the year to June has been broadly comparable
between large and small business, although small business credit (loans under
$500,000) has been growing consistently at around half the pace of that to
large business. Large firms may have switched to obtaining funding directly
from financial markets. Fund raising through non-intermediated debt remained
at reasonable levels in the six months to September, with issuance for much
of 2001 concentrated in bonds at the expense of commercial paper, perhaps reflecting
perceptions of favourable rates for long-term funding. To date in 2001, equity
raisings have been around the average levels of recent years, with particular
strength recorded in the September quarter, predominantly through private placements
rather than floats. When taken together, however, net external fund raisings
thus far in 2001 have been somewhat lower as a share of GDP than in the past
several years (Graph 47).

Graph 46

Graph 47

Commonwealth budget

The Government announced that the Commonwealth budget recorded an underlying cash
surplus of $5.6 billion in 2000/01 (Table 10). This was around $2.8 billion
higher than was originally estimated in May 2000, despite the fact that the
economy's growth rate for the year was about half as strong as forecast.
Tax receipts from both companies and individuals were considerably higher than
initially expected (by about $6.7 billion or 1 per cent of GDP), partly due
to the lower than expected take-up of deferral arrangements for paying company
tax and perhaps reflecting an expansion of the tax base following the introduction
of the new tax system. As a partial offset, however, government spending was
also higher than forecast, due to several factors including the introduction
of a range of discretionary spending initiatives mainly affecting the second
half of the year.

Table 10: Commonwealth Government Underlying Cash Balance

$ million, per cent of GDP

1999/2000

2000/01

2001/02

2002/03

Budget, May 2001

12,671

2,253

1,520

1,063

(2.0)

(0.3)

(0.2)

(0.1)

MYEFO, October 2001

12,671

5,625

502

991

(2.0)

(0.8)

(0.1)

(0.1)

Source: Commonwealth Treasury

In October, the Commonwealth Government updated its economic forecasts and estimate
of the budget position in the Mid-Year Economic and Fiscal Outlook (MYEFO).
The expected underlying cash surplus for 2001/02 was revised down by $1 billion
to around $500 million, and the estimate for 2002/03 was broadly unchanged.
The revision for 2001/02 reflected an upward revision to expenses arising from
discretionary policy decisions and the effect of higher forecasts for CPI inflation
and wages growth, although this was partly offset by upward revisions to revenue.

The revised estimates of the underlying cash surplus in recent and forthcoming years
suggest that the fiscal impact on growth, including the contribution of automatic
stabilisers and discretionary measures, was around 1¼ percentage
points in 2000/01 and will be around ¾ of a percentage point this year. At
this stage, state budget estimates imply that very little fiscal stimulus is
likely to come from the states.

The labour market

Labour force data and partial indicators of labour demand indicate that conditions
in the labour market continue to be weak (Graph 48). Employment increased
by 0.5 per cent in the three months to October, to be 0.5 per cent above the
corresponding period a year earlier. The participation rate has remained, on
average, around 63.8 per cent
over the past six months, and the unemployment rate has averaged 6.9 per cent. In
October, however, the unemployment rate increased to 7.1 per cent.

Graph 48

While total employment growth has been weak through most of the past year, the full-time
and part-time components have exhibited markedly different trends and considerable
volatility. Full-time employment has declined over the past year, to be 1.1
per cent lower in the three months to October than a year earlier. Part-time
employment, on the other hand, increased by 5.0 per cent over this period.
The considerable volatility from month to month in these components is difficult
to explain. An increase in the proportion of workers who are working around
35 hours, the cut-off used by the ABS in its classification of workers as being
full-time versus part-time, may have contributed. The temporary employment
of workers by the ABS to conduct the Census is estimated to have had little
effect on these figures. Interestingly, in previous periods of labour market
weakness there have been similar increases in the monthly volatility of full-time
and part-time employment, as well as similarly divergent trends in these components.

As is the case for developments in economic activity more generally, the aggregate
employment numbers also mask divergent trends across industries (Table 11).
Employment in the construction industry increased by 1.2 per cent
over the three months to August, following a slight increase over the three months
to May. While this growth appears to be relatively modest compared with the
increase in construction output that the national accounts and forward indicators
of dwelling construction activity have implied for the June and September quarters,
it suggests that measured labour productivity in the construction industry
may be in the process of returning to more normal levels, having fallen to
very low levels during the second half of 2000. Employment in the manufacturing
industry has remained weak, falling by 3.1 per cent over the three months to
August following a small fall over the previous three months, largely due to
continued falls in employment in the construction-related parts of the manufacturing
sector. The weakness in the output of the business service industries over
the last six months has corresponded with a decline in employment in these
sectors. (See Box A on ‘The Service Sectors’
for a further discussion of these developments.)

Table 11: Employment by Industry

Per cent

Industry share

Growth

3 months to August

Year to August

Public-related(a)

21

2.4

5.1

Retail and wholesale trade

20

1.7

1.5

Business services(b)

18

−2.4

−0.2

Manufacturing

12

−3.1

−4.8

Household services(c)

12

1.4

1.9

Construction

7

1.2

−5.3

Mining and agriculture

5

2.9

0.3

Transport

5

2.0

1.0

(a) Electricity, gas and water; public administration and defence; health;
education (b) Communication; finance and insurance; property and business
services (c) Accommodation, cafes and restaurants; cultural and recreational
services; personal and other services

Source: ABS

The Victorian labour market has continued to be the most resilient of all the state
labour markets, recording the highest growth in employment over the year to
the latest three months (Table 12). Above-average growth in employment
has also been recorded in both Western Australia and Queensland, over the past
year, while employment in South Australia and Tasmania has fallen.

Table 12: Labour Market by State

Per cent

Employment growth

Unemployment Rate

Three months to October

Year to three months to October

Three months to October

NSW

0.2

0.1

6.3

Victoria

0.3

1.1

6.5

Qld

0.7

1.0

8.1

WA

0.5

0.6

6.9

SA

0.3

−0.8

7.2

Tasmania

0.2

−0.8

9.3

Australia

0.5

0.5

6.9

Source: ABS

Labour productivity, as measured by output per hour worked in the non-farm economy,
increased by 1.2 per cent in the June quarter, after having exhibited little
growth over the preceding year. Short-term developments in productivity always
reflect both trend and cyclical movements, which cannot easily be separated,
but productivity outcomes during the past year or so have been similar to the
experience of the mid-1990s slowdown.

Forward-looking indicators of the labour market have been mixed. The major business
expectations surveys, taken before the events of mid September, had recorded
a significant improvement in the outlook for the labour market in the second
half of 2001, on the back of the improvement in business conditions more generally
(Graph 49). This improvement was not, however, reflected in the vacancies
data. While the ANZ and Department of Workplace Relations and Small Business
(DEWRSB) newspaper-based vacancy indexes had stopped falling, they were broadly
flat over the six months to September. The ABS employer-based measure of vacancies
fell by 3.5 per cent
in the September quarter, although its pace of decline has also slowed. Since mid
September, most surveys have presented a more subdued outlook for the labour
market. The October DEWRSB and ANZ vacancies indexes both recorded declines,
although these were not particularly large by historical standards. Overall,
these forward-looking indicators suggest that employment will remain soft for
a while yet.

Graph 49

Box A: The Service Sectors

The service sectors have contributed strongly to economic growth in recent years.
During the second half of 2000, in particular, growth in some service industries
partially offset the weakness in output in those industries of the economy
exposed to the downturn in dwelling construction (Graph A1). More recently,
as the recovery of dwelling construction has gained momentum and growth in
the goods-related sectors has thus recovered, there are signs that some service
industries are slowing.

Graph A1

For this analysis the economy has been divided into four groupings, based on whether
industries are primarily involved in goods production, goods distribution,
supplying services to businesses or supplying services to households. On this
basis, the service sectors, which encompass the latter two categories, account
for around 45 per cent of total output and employment, about the same as the
goods-related sectors (Table A1).
Within the service sectors, services provided to businesses contribute the larger
share of output, while those provided to households, which tend to be more
labour intensive, account for a larger share of employment.

Table A1: Indicators of Activity by Industry Groups(a)

Per cent

Share of output
2000/01

Share of employment
2000/01

Average output growth
1992/93–1999/2000

Goods production(b)

25.4

21.5

3.7

Goods distribution(c)

16.4

24.2

5.1

Business services(d)

22.8

17.6

6.2

Household services(e)

17.8

27.9

3.4

(a) The propensity of an industry to service households versus businesses
was determined using input-output tables, and an industry was deemed
to supply households if more than 50 per cent of its total supply was
allocated to final consumption by households. (b) Manufacturing, construction, mining and utilities. (c)
Wholesale and retail trade, and transport and storage. (d) Property
and business services, finance and insurance, and communications services. (e) Accommodation, cafes and restaurants, education, health and community services,
cultural and recreational services, and personal and other services.

Source: ABS

During the past decade, growth in the service sectors has, on average, been greater
than that in the goods-related sectors. In the past few years, growth in the
business services industries has been particularly rapid, reflecting several
factors such as the preparations for Y2K, the new tax system, and, to a lesser
extent, the Olympics, as well as the expansion of telecommunications networks
following the deregulation of the domestic telecommunications industry. Each
of these developments created a large temporary increase in demand for specialist
services, especially in the fields of information technology and communications
(ITC), accounting and consultancy. The reduction in demand from these sources
would have, of itself, contributed to a slowing in activity in the business
services sector. It has, however, been exacerbated by the global downturn
in ITC activity, and the more general cyclical slowing in growth that has
taken place.

In recent years, growth in the household services sector has also been relatively
strong, underpinned by growth in the health, accommodation, cafes and restaurants,
and personal services industries. Over the past year, the resilience of the
household services sector has been due mainly to the continued strength in
demand for health services, with an easing in demand being recorded in many
of the other major components. As discussed in the section on household consumption,
the strength in demand for health services appears to be largely because of
federal government incentives to take up private health insurance.

The disparate performances of the business and household service sectors has been
reflected in the labour market. Business services employment is now lower
than a year ago, the first such annual decline recorded since the early 1990s
(Graph A2). Employment in household services, on the other hand, continues
to grow relatively strongly.

Graph A2

A continuation of the slowing in business services output is in prospect, with job
vacancies falling sharply across a range of job types in the sector (Graph
A3). This includes falls in vacancies in areas where special factors are no
longer supporting demand – such as in ITC and accounting. However, falls
are also evident in areas of the business services sector that are most exposed
to changes in discretionary spending by firms, such as marketing and advertising.

Graph A3

While services supplied to households have recently been supportive of growth, their
growth is also likely to slow. The potential for further strong growth in
health services, for example, could be limited as coverage by private health
insurance reaches saturation levels. The recent reduction in domestic and
international airline travel will also have reduced demand for tourist-oriented
services during the second half of 2001.

Box B: The Tourism Industry

Tourism makes a significant contribution to economic activity in Australia and to
Australia's exports. While measuring the size of the tourism industry
is quite difficult, the ABS has estimated that in 1997/98, the tourism industry
accounted for 4.5 per cent of GDP (Table B1). This implies that it is roughly
similar in size to the education and mining industries. Over three-quarters
of tourism output is consumed by domestic tourists, who mainly comprise households
but also include businesses and
government.[1]

Table B1: The Tourism Industry

1997/98

Domestic(a)

International(b)

Total

Households

Business/Government

Tourism expenditure ($m)

38,770

6,596

12,792

58,158

Tourism output ($m)

17,026

2,755

5,394

25,174

– as a per cent of GDP

3.0

0.5

1.0

4.5

Tourism share of employment (%)

–

–

–

6.0

(a) Includes expenditure by outbound Australian residents before and after
overseas trips. (b) This figure is conceptually different from the comparable
balance of payments statistic.

Many parts of the economy are involved in the provision of goods and services to
tourists. Around two-thirds of tourism output, however, is contributed by
the transport and storage, accommodation, cafes and restaurants, and retail
and wholesale trade industries (Table B2). The transport and storage industry
makes the largest contribution to tourism output, principally due to the use
of air travel by both domestic and international tourists. The accommodation,
cafes and restaurants industry, however, is the most tourism dependent, with
around 36 per cent of its output directly attributable to the tourism industry.

The tourism industry is highly export oriented, contributing around 11 per cent of
Australia's total export earnings even though it accounts for only 4.5
per cent of output (Graph B1). In part, this reflects the different characteristics
of the international and domestic tourist markets. Although the high share
of business tourists among domestic tourists implies that the average domestic
tourist tends to spend much more per night than the average international
tourist, over the course of their stay, the average international tourist
spends considerably more (Table B3). This in turn probably reflects the fact
that the average short-stay international tourist is relatively high spending,
while there are also a significant number of international tourists (for example,
backpackers) who, although not wealthy, spend a considerable amount because
of the length of their stay.

Graph B1

Table B3: Tourist Characteristics

2000

Domestic tourists(a)

International tourists

Households

Business

Total

Tourists (million)

59

15

74

4

Tourist nights (million)

249

45

293

113

Average nights per tourist

4

3

4

26

Average expenditure per tourist(b) ($)

459

647

496

2168

Average expenditure per night(b) ($)

109

212

125

83

(a) Overnight travel within Australia by Australian residents. (b) For international tourists, excludes pre-paid package tours
and pre-paid international airfares.

Sources: National Visitor Survey and International Visitor Survey,
Bureau of Tourism Research

Recent developments

The collapse of Ansett and the US terrorist attacks were associated with a sharp
fall in airline travel. Given that air transport makes a large direct contribution
to the output of the tourism industry and facilitates tourism more generally,
the recent downturn in airline travel has had a significant and immediate
effect on the tourism industry.

Ansett accounted for approximately 40 per cent of the domestic aviation market (both
passenger and freight) and around 3½ per cent of international passenger
movements to and from Australia. There has been a sizeable decline in domestic
air services in the past couple of months, although liaison suggests that
it has been much less than during the pilots' strike of 1989 (Graph B2).
The magnitude of the fall in international passenger movements is hard to
establish, although the Tourism Forecasting Council has revised down its forecast
for overseas arrivals in the December quarter by around 15 per cent.

Graph B2

The effect on aggregate output in the economy of these developments is dependent
on a number of factors. Most importantly, it depends on the initial size of
the contraction in the tourism industry, and the extent to which domestic
consumers substitute spending on other goods or services for the spending
they would otherwise have directed towards tourist activities (both domestically
and internationally). Secondly, it depends on the flow-on effects of these
developments to other industries. Finally, it depends on the time it takes
before both the capacity of the domestic airline industry is restored to satisfy
demand and international tourism recovers.

It will be difficult to predict the relative sizes of these effects with any accuracy.
Around 17 per cent of domestic tourists use airline travel as their main mode
of transport, although much higher figures are recorded for the Northern Territory
and Tasmania (Graph B3). The variation in these figures across states reflects
both the feasibility and accessibility of alternative modes of transport and
differing shares of interstate tourists. Overall, however, these data illustrate
that a large proportion of domestic tourists are not reliant on air transport,
and they suggest that there may be some scope for substitution as, for example,
domestic tourists choose holiday destinations to which they can drive rather
than fly. If Australia benefits from a safe-haven status, it could also encourage
the replacement of overseas travel with domestic travel and attract international
tourists from other destinations. The latter factors appear to have played
a role during the Gulf War, and the former during the pilots' strike.
In both cases, aggregate economic activity was little affected by the significant
shocks to airline travel that occurred.

Graph B3

However, there are also forces that may inhibit the recovery of tourism and so generate
more pervasive effects on economic activity. The weakened financial position
of creditors to Ansett, particularly small businesses, may inhibit spending.
Heightened concerns about flying could also imply that it takes longer before
the demand for tourist-related activities recovers. More generally, given
that tourist expenditures are to some extent discretionary, and given the
tourism industry's reliance on exports, it may be more exposed than most
industries to any further deterioration in domestic and global prospects.

Balance of Payments

The slowdown in the world economy over the course of the year has been reflected
in slower growth in export volumes and a decline in the world price of a number
of commodities, both exported and imported by Australia. The low level of the
exchange rate, however, has helped insulate the economy from the full effects
of moderating external demand. Import volumes continued to fall in the September
quarter, offsetting a decline in export volumes, so that net exports are likely
to have had little impact on GDP growth in the quarter, after adding two percentage
points to growth over the year to the June quarter. Primarily reflecting the
likely rise in the terms of trade in the September quarter, the trade surplus
widened further, after the first surplus in four years was recorded in the
March quarter (Graph 50). Consequently, the current account deficit is
likely to have narrowed further from its 20-year low in the June quarter, to
be around 1¾ per cent of GDP in the September quarter, assuming no change
in the net income deficit as a share of GDP.

Graph 50

Some of the narrowing in the current account deficit over the past couple of years
is the result of an improvement in Australia's terms of trade, which have
risen by about 9½ per cent from the Asian-crisis lows. The rise in the
terms of trade has also provided a significant boost to domestic incomes and
living standards. It is unusual for Australia's terms of trade to be rising
at this stage of the world economic cycle, and this reflects the strength in
some export prices, particularly coal and beef prices, as well as falling prices
for electronic goods, which Australia imports. The weaker world outlook may
be reflected in falls in the prices of rural and resource commodities in the
period ahead, but the effect on the terms of trade will be limited by the prospect
of further falls in the prices of electronics and other manufactured goods.

The value of exports fell in the September quarter, but is still 6 per cent higher
over the year. The decline was particularly large in manufactured exports.
Merchandise export growth to most regions has slowed over the past year, though
this has been particularly noticeable for exports to those regions experiencing
the sharpest downturns, such as countries in east Asia (Graph 51). The
slowing in demand from the ITC-producing countries, such as Singapore and Taiwan,
has been most pronounced. Growth in exports to Japan, while slowing, has been
underpinned by firm demand for resources and, to a lesser extent, rural products.
The strongest growth in the value of merchandise exports over the past year
has been to China, where export values have risen by just under 40 per cent.
These exports may receive a further boost following China's accession into
the WTO. With growth in the major regions slowing simultaneously, however,
Australian exporters will find it more difficult to divert products to alternative
markets than was the case during the Asian crisis.

Graph 51

The value of resource exports fell in the September quarter, though this followed
a large rise in the previous quarter (Graph 52). After adjusting for probable
movements in resource prices in the September quarter, there appears to be
some levelling out in resource export volumes over the past few quarters. Looking
ahead, the low levels of spending on exploration and investment in mining in
recent years will continue to limit growth in production. According to the
Australian Bureau of Agricultural and Resource Economics (ABARE), Australian
mine production will rise by around 1 per cent in 2001/02, compared with an
increase of nearly 7 per cent in 2000/01. Production of base metals is forecast
to increase by around 2 per cent in 2001/02. Production of energy is forecast
to remain fairly flat with a moderate expansion of production in the coal,
uranium and gas industries being offset by lower output of crude oil owing
to a decline in productivity of a number of mature oil fields.

Graph 52

The value of rural exports has continued to rise due to high levels of production
and firm prices. The gains have been particularly marked in meat exports, although
growth in the Japanese market, which accounts for more than one-third of Australia's
beef and veal exports by weight, has slowed recently following the discovery
of ‘mad cow’ disease in Japan. The value of cereal exports has
been flat this year as production has fallen from the very high levels recorded
in the past three years. Higher livestock prices have also encouraged some
substitution away from crops. Wool exports have softened due to wool supply
being at an historic low. According to ABARE, the volume of farm production
is expected to increase by a little over 1 per cent in 2001/02. Increases in
beef and veal production are expected to be partially offset by small declines
in crop production and a reduction in the supply of wool.

The manufacturing and service export sectors tend to be most affected by weakness
in the world economy (Graph 53).
Manufactured export volumes, after growing by 17 per cent over the year to the March
quarter, fell in the June quarter and are likely to have fallen again in the
September quarter, reflecting the weakness in Australia's trading partners,
with a marked slowdown in exports of machinery. Growth in service exports,
after abstracting from the Olympics, has moderated over the past year, although
the value of service exports rose in the September quarter, boosted by a pick-up
in sports-related arrivals. However, overseas arrivals fell by
4 per cent in September, with sharp falls in arrivals from the US and
Japan.

Graph 53

The slower growth in domestic demand over the year to June, combined with the low
exchange rate, was reflected in a fall in import volumes over the past year
(Graph 54). The decline in import volumes has been broad-based,
with large falls recorded in imports of capital and intermediate goods, both of which
declined by more than 9 per cent over the year to June (Graph 55). The
outcome for capital goods was in line with weak investment over the past year,
though the disproportionately large fall in capital imports suggests that firms
may have increasingly sourced their capital goods from domestic producers,
most likely in response to higher capital import prices. The import penetration
ratio has steadied over the past year or so, after being on a strong upward
trend for most of the 1990s.

Graph 54

Graph 55

The net income deficit in the June quarter remained around 3 per cent of GDP, where
it has been for more than three years. The ratio of net interest payments to
exports fell to under 9 per cent in the June quarter owing to payments on net
debt declining as interest rates fell, and exports rising. This compares with
a peak of over 20 per cent in 1990.

There were substantial net equity inflows and debt outflows in the June quarter,
in contrast to the trend evident since mid 1999. There has been a noticeable
pick-up in net portfolio equity investment inflows from the US in 2001. Australia's
net foreign debt fell in the June quarter to $311 billion, or 46 per cent of
GDP, though this was offset by an increase in net foreign equity liabilities
(Graph 56). Overall, net foreign liabilities remain at just under 60 per
cent of GDP.

Graph 56

Commodity prices

The RBA commodity price index has fallen in foreign-currency terms by a little over
2 per cent from its peak in June, although it is still about 15 per cent higher
than the trough recorded in the first half of 1999. The trend in this index
has been quite different to that of some other commonly used indexes, notably
the CRB index (Graph 57).
This reflects the stronger performance of key rural and resource prices over the
past year. In Australian dollar terms, commodity prices are at very high levels
and are 43 per cent higher than the low point reached in early 1999, partly
due to the depreciation of the exchange rate since then.

Graph 57

Rural commodity prices have risen over the course of this year, but prices for some
rural commodities have begun to ease over the past month or so (Table 13).
Beef and veal prices remain high as restrictions on South American beef exporters,
arising from concerns about foot and mouth disease, and drought conditions
in parts of the US have limited global supply. Wool prices, however, have edged
lower as Chinese demand has softened and European buyers have been largely
absent from the market.

Table 13: Commodity Prices

Percentage change; SDR terms

October

Latest 3 months

Year to latest 3 months

Rural

−4.2

−0.8

3.3

– beef and veal

−3.6

11.8

23.6

– wool

−6.8

−8.4

−0.5

– wheat

1.7

−0.2

11.2

– sugar

−15.3

−17.5

−23.1

Base metals

−3.6

−12.1

−18.0

– aluminium

−4.1

−11.3

−12.3

– copper

−3.0

−13.1

−24.2

– nickel

−4.0

−23.3

−35.7

– lead

1.3

1.2

−0.7

Other resources

0.2

1.4

12.9

– gold

0.3

1.5

3.9

RBA Index

−1.7

−1.2

4.9

Memo items:

Oil in US$ (a)

−15.8

−8.0

−22.6

Coal in US$ (b)

−0.1

−3.9

28.3

(a) Oil prices are not included in the RBA Index. (b) Spot price for
steaming coal from the Australian Coal Report; latest observation
is for September.

Base metals prices have continued to fall, reflecting the deterioration in the outlook
for world growth (Graph 58). Aluminium prices, which had held up early
in the year due to the effects of production cuts in the US, have resumed their
downward trend, in line with most other base metals prices. Demand from the
automotive, consumer durable and engineering sectors in the US has declined
quite sharply, while falling electricity prices have increased the possibility
of an expansion in US production. Nickel and copper prices have been under
considerable downward pressure following slowing demand and a consequent build-up
in inventories.

Graph 58

The price of gold rose to over US$290 an ounce following the terrorist attacks in
the US, with the commodity receiving some ‘safe-haven’ support.
It has since returned to around US$270, where it has traded for much of the
past year. In Australian dollar terms, however, the gold price is back around
the highs of the Asian financial crisis. Preliminary negotiations are under
way for next year's round of price-setting for coal and iron ore contracts.
Spot prices for thermal coal have eased recently, though they remain close
to the contract prices due to tight supply conditions. Industry analysts expect
reductions in world steel production to limit any upward pressure on iron ore
and coking coal prices.

After spiking briefly following the terrorist attacks on the US, oil prices have
fallen below the bottom of OPEC's target range, with the benchmark West
Texas intermediate oil price now trading at around US$20 a barrel, a two-year
low (Graph 59). The weaker global outlook was the main factor behind the
fall. Despite the approaching northern hemisphere winter and talk of OPEC production
cuts, oil prices are expected to remain subdued in the near term, reflecting
softness in world demand.

Graph 59

Some of Australia's imports are also experiencing long-term price declines typical
of the trend decline in the prices of rural and resource commodities that has
occurred over past decades. Telecommunications and data processing equipment,
which account for just under 10 per cent of Australia's imports, have experienced
large price reductions over the past ten years. This primarily is a result
of the fall in the price of electronic hardware underpinned by sharp declines
in the price of memory chips, as well as falling software prices reflecting
technological innovations. Lower prices for a range of internationally traded
manufactured goods have also been a feature of recent years.

The fall in import prices, which has been particularly marked since the mid 1990s,
has contributed to a rise in the terms of trade, boosting living standards
in Australia (Graph 60). The terms of trade have risen almost continuously
since their late-1998 trough. More recently, the fall in technology-related
prices has provided a significant boost to the terms of trade in circumstances
during which, historically, the terms of trade have tended to decline.

Graph 60

Domestic Financial Markets

Market interest rates

Renewed concerns about prospects for the global economy have seen further significant
falls in market interest rates on both short and long-term debt in Australia
in recent months. This trend accelerated late in the quarter following the
terrorist attacks in the US.

Around the middle of the year, expectations for further monetary easing in Australia
had largely disappeared as markets increasingly recognised the continuing good
performance of the domestic economy. In August, however, expectations of a
further easing in domestic monetary policy began to emerge. The main force
behind this was the increasing gloom about the global outlook, as this was
seen as eventually weighing on the domestic economy. Concerns about the international
economy have continued to be an important influence on markets since. They
were reinforced by the events of 11 September.

The first easing of monetary policy took place on 5 September, and although the money
markets took it in their stride, there were some views expressed doubting the
need for action at that time. The second easing a month later, and therefore
after the events of 11 September, was fully anticipated and caused no reaction.
The two reductions have taken the cash rate to 4.5 per cent, 25 points below
the previous low which occurred in both the late 1990s and early 1990s (Graph 61).
Comparisons further back in history are complicated because targets for the
cash rate were not announced before the 1990s, but the last time the cash rate
had averaged a level this low over a month was in 1973.

Graph 61

Yields on 90-day bank bills have fallen a little more than the cash rate in recent
months as markets have priced in additional monetary easings in the months
ahead. Yields are currently at 4.2 per cent, compared with a little over 5
per cent in early July. Like the cash rate, the current level of bill yields
is the lowest for about 30 years.

The decline in interest rates in Australia has been smaller than has occurred in
the US. Hence the spread between the cash rate in the two countries has widened
to 250 basis points from 125 basis points in mid year (Graph 62). Markets
expect this differential to narrow a little over coming months.

Graph 62

A positive spread between Australian and US cash rates has been the norm, though
there was an unusual period in the late 1990s when the Australian rate was
below that in the US. The current spread is higher than in the mid 1990s but lower than that in the early
1990s.

Yields on medium and long-term bonds in Australia have also declined by significant
margins in recent months. Bond yields started the September quarter at their
highest levels for 2001. However, the deterioration in the global economic
outlook that emerged midway through the quarter and the consequential concerns
about Australia's growth saw bond yields fall sharply from around 6.25
per cent in July, to around 5.50 per cent by early September. The terrorist
attacks in the US resulted in further modest declines in long-term interest
rates, as did the lower-than-expected CPI outcome in late October. Yields on
10-year bonds are now around 5.0 per cent, around 120 basis points lower than
at the start of July (Graph 63).

Graph 63

The differential between Australian and US bond yields – which had widened
significantly over the June quarter as prospects for the two economies diverged
– has tended to move in a fairly stable range of between 70 and 100 basis
points over recent months. Most recent trading has been around 85 basis points.

The events in the US on 11 September generated a sharp increase in banks' demand
for liquidity when Australian markets opened the following day. Like other
central banks, the RBA responded with substantial injections of liquidity to
meet the demand (see Box C). In the event, the payments system was able to
continue operating normally, although trading in some securities markets remained
subdued for several days.

Interbank price-making in the underlying market for Treasury and semi-government
bonds was very limited for a few days after the terrorist attacks and client
business was undertaken on a ‘best endeavours’ basis. In contrast
to the lower activity in physical bond and repo markets, trading in interest
rate futures and options on the Sydney Futures Exchange was little affected
in the aftermath of 11 September. The futures market played an important role
in facilitating risk management and price discovery through this period.

Corporate bond yields have fallen in recent months, but not as much as government
yields – i.e. there has been a rise in the credit spreads on corporate
bonds (Graph 64). The events of 11 September were an important factor.
Except for the lowest-rated bonds, about three quarters of that rise has now
been reversed.

Graph 64

There was virtually no trading in the corporate bond market in the first two days
after 11 September. While trading of domestic issues resumed on Friday 14 September,
market-makers were reluctant to trade bonds issued by US investment banks and
insurance companies because of their direct exposure to US events. Although
trading in AAA-rated bonds and bonds issued by Australian banks returned to
normal levels by 20 September, for the overall market trading volumes were
around one-third their normal level. The Australian experience was similar
to that seen in overseas markets; trading in investment-grade bonds was running
at about a third of normal volumes in the US and Europe in the week ending
21 September.

Australian credit spreads remain well below US spreads. In the US, adjustment to
the 11 September shock has come through a sustained widening in spreads rather
than a decline in issuance volumes, which have continued at high levels (Graph 65).
By contrast, adjustment in our market (and the European market to some extent)
is working mainly through quantity (see ‘Debt
markets’ below).

Graph 65

Intermediaries' interest rates

Reductions in the cash rate target in September and October were passed on completely
and quickly to almost all borrowers offering residential property as security
(ordinary mortgages, home equity personal loans and residentially secured small
business loans). Interest rate reductions have been smaller for small businesses
offering other security, and for credit card borrowers.

All types of mortgage lenders have passed on in full to residential mortgage rates
both the September and October easings in policy (Graph 66). The current
average standard variable rate of the banks, at 6.3 per cent, is 20 basis points
below the previous cyclical low in 1999 and is at its lowest level since March
1970. The average basic rate fell to 5.75 per cent, the lowest mortgage rate
since July 1968.

Graph 66

In the case of small business loans, not all banks have passed reductions in the
cash rate on to all types of loans. Whereas the margin between the cash rate
and small business loans secured by residential property has remained roughly
constant, the margins for other small business loans have widened in the past
two months (Table 14). When combined with the increase that occurred in
the first half of 2000, as banks increased some business lending rates independently
of changes in the cash rate, the margin is now up to 40 basis points above
its level in 1998/99.

Table 14: Banks' Indicator Lending Rates

Per cent

Current level (early November)

Change since August 2001

Change since January 2001

Cyclical low 1998/99

Household

Mortgages

– Standard variable

6.30

−0.50

−1.75

6.50

– Basic housing

5.75

−0.50

−1.75

5.90

– Mortgage managers

6.00

−0.50

−1.80

6.10

– 3-year fixed

6.30

−0.50

−0.65

6.40

Personal lending

– Residential secured

6.45

−0.55

−1.75

6.60

– Credit cards

15.90

−0.10

−0.80

15.25

Small business

Residential secured:

– Overdraft

6.95

−0.45

−1.65

6.95

– Term loan

6.45

−0.55

−1.65

6.65

– 3-year fixed

6.20

−0.80

−0.80

6.50

Other security:

– Overdraft

7.60

−0.40

−1.60

7.45

– Term loan

7.15

−0.30

−1.55

7.05

Large business

– Overdraft

8.05

−0.45

−1.70

7.95

– Term loan

7.95

−0.45

−1.65

7.90

Cash rate

4.50

−0.50

−1.75

4.75

Source: RBA

For mortgage and small business loans that carry a fixed interest rate, the interest
rates at which new loans are being offered have fallen in line with rates in
capital markets. The declines have brought most fixed rates to levels close
to their low points of earlier this year and similar to the cyclical low points
reached in 1998. Approvals for fixed-rate housing loans have remained below
10 per cent of total housing loan approvals so far this year (Graph 67).

Graph 67

Capital markets developments

Debt markets

Domestic non-government bond issuance was again strong in the September quarter,
totalling $9 billion(Graph 68).
The proportion of issues in the form of asset-backed securities rose to about half.
Issues of asset-backed securities have remained strong since the terrorist
attacks, though issues of corporate bonds have fallen away (Table 15).
Total non-government bonds outstanding are now just over $100 billion.

Graph 68

Table 15: New Issuance by Sector

$ billion

Sector

2001

2000

1999

October

Sep qtr

June qtr

Financials

0.40

1.7

1.0

5.1

10.1

Non-residents

0.10

1.2

2.4

3.5

5.6

Corporates

0.05

1.5

1.9

8.3

5.0

Sub-total

(Non-asset-backed)

0.55

4.4

5.3

16.9

20.7

of which:

– Credit-enhanced

0.00

0.9

1.2

3.8

0.0

– Floating rate notes

0.15

1.4

1.5

6.5

1.1

Asset-backed

0.80

4.5

2.7

10.6

5.9

Total issuance

1.35

8.9

8.0

27.5

26.6

Source: RBA

The strong increase in asset-backed securities, most of which have been residential
mortgage-backed, reflects solid demand for housing loans in the economy. There
has been a strong appetite from overseas investors for these bonds, and an
increased proportion of asset-backed deals has been placed directly in offshore
markets. During the September quarter, about half of all asset-backed securities
were issued offshore.

Although most asset-backed securities are backed by residential mortgages, the domestic
asset-backed market has become more diverse, with issues of securities backed
by car loans, yet-to-be completed residential units and non-conforming residential
loans during the September quarter. (Non-conforming borrowers include those
with a history of not meeting repayments or those whose credit history is difficult
to establish, such as the self-employed and new migrants.)

The asset-backed sector was, briefly, adversely affected by the terrorist attacks
in the US. Most issuers of residential mortgage-backed securities rely on mortgage
insurance to support the credit quality of their securities. Ratings agencies
placed a number of residential mortgage-backed securities on negative credit
watch in the light of concerns about their mortgage insurer's exposure
to losses in the US, though these were subsequently removed in mid October.

Issuance by corporates was a modest $1.5 billion in the September quarter. While
issuance began the quarter strongly, it slowed in August and ground to a halt
in September. Only four non-asset-backed issues have been placed in the domestic
market since then. Broader concerns about corporate credit quality have also
held back issuance. Out of the 114 rated entities in the corporate sector of
Australia and New Zealand rated by Standard and Poor's, 32 corporates have
been downgraded this year while only seven have been upgraded.

Issuance is expected to be boosted in coming months in order to refinance a large
number of maturities of existing corporate bonds. Scheduled maturities over
the December quarter amount to $4.4 billion, almost double the total volume
of maturities observed throughout the previous three quarters (Graph 69).
Prospective maturities for 2002 stand at $9.8 billion, compared with $6.7 billion
in 2001.

Graph 69

Changes to the associates test applied when determining whether debt security holdings
are subject to interest withholding tax were announced in early September.
Onshore associates (Australian residents or non-residents conducting business
through a permanent establishment in Australia) of domestic debt issuers will
now be exempt from interest withholding tax.

Equity markets

Whereas most share market indices overseas have been falling since early 2000, the
Australian market continued to rise through to mid 2001. It did not experience
the excesses seen overseas in earlier years, and therefore has not been not
subject to the corrections now taking place overseas. Even though the Australian
market fell over July and August, the falls were smaller than those overseas,
so the relative performance continued to improve. The immediate reaction to
the terrorist attacks was very similar across most countries, including Australia,
as was the subsequent recovery (Graph 70).

Graph 70

The Australian share market index is currently about 6 per cent below its peak, whereas
markets in most overseas countries are down about 25–40 per cent from
their peaks, most of which were in early 2000. This relatively strong performance
of the Australian market has helped to close the gap that opened up between
the Australian and overseas markets in earlier years. Since 1995, the Australian
market has risen by a net 50 per cent, which is the same as the increases in
the UK and Canada, though still less than the increase of around 70 per cent
in the broad US indices. Part of the divergence between the Australian and
the US markets can be attributed to the different policies relating to dividend
payments and share buy backs in the two countries (see Box D).

The Australian share market remained open throughout September, and no operational
problems were reported. Trading levels at the Australian Stock Exchange and
in the market for Share Price Index futures at the Sydney Futures exchange
were around historical norms.

In August and September most of the largest listed companies reported their results
for the first six months of this year. Overall, profits were flat compared
with those earned in the first half of 2000. These results were broadly in
line with market expectations. Profits for the full year 2000 were up by 32
per cent.

Industrial companies' profits fell 6 per cent in the latest half year. This outcome
was affected by the losses in the media sector due to weakness in advertising
revenue and losses on investments. Banks performed strongly compared to the
other sectors with a rise of 20 per cent. For industrial companies other than
in the bank and media sectors, profits fell 3 per cent. Resource companies
produced a 35 per cent increase in profits in the first half of 2001, higher
than the banking sector.

During the course of the past year, analysts' expectations for earnings growth
have been revised down. Downward revisions in earnings estimates through the
year tend to be the norm, but those for 2001 were larger than usual (Graph 71).
Currently, analysts expect full-year 2001 earnings per share to be only slightly
above last year's results. Expected earnings per
share are up by 15 per cent in 2002.

Graph 71

The Australian Price Earnings (PE) ratio has been fairly steady this year and is
currently 23 (Graph 72). In contrast, the US PE ratio has risen over the
past few months to stand at 29. This has occurred despite the fall in share
prices, and reflects the very sharp falls in corporate profitability in that
country.

Graph 72

The 11 September events caused the deferment of some initial public offerings. For
the September quarter as a whole, initial public offerings were slightly down
on the levels seen in the previous quarter, with 15 companies raising a total
of $297 million. Such raisings have slowed sharply in October.

In contrast, equity raisings by existing listed companies (for example, via placements
and rights issues) have remained strong into October (Graph 73). During
October, $1.5 billion was raised via placements. Moreover, the two largest
raisings in October were oversubscribed.

Graph 73

The strength of total equity raisings through the September quarter was not sufficient,
however, to offset the slowdown in non-intermediated debt raisings and the
fall in intermediated credit. Total business external funding was $3.2 billion,
well below the levels seen in previous quarters.

Growth in margin lending for equities and managed funds during the September quarter
was well down on the rapid growth seen in the previous 12 months (Table 16).
There was almost no change in the average level of credit limit usage but average
leverage increased slightly between the June and September quarters. In response
to the volatility of markets during the month of September, the number of margin
calls was high relative to past quarters.

Table 16: Margin Lending

Level at end Sep 2001

Growth (per cent)

Three months to Sep 2001

Year to Sep 2001

Total margin debt ($b)

8.5

0.4

60

Total margin loans approved ($b)

13.1

−0.6

17

Credit limit use (per cent)

64.9

Value of underlying shares ($b)

17.4

−7.1

40

Leverage (per cent)

49.2

Number of margin loans

98,400

3.9

16

Number of margin calls

65,600

245

610

Source: RBA

Box C: Bank Liquidity in the Aftermath of 11 September

Central banks around the world sharply increased the supply of liquidity to their
financial institutions in the aftermath of 11 September, to ensure that financial
systems continued to operate without disruption. This box explains what that
meant in the Australian context.

Broadly speaking, the ‘liquidity’ of an institution refers to its capacity
to meet short-term financial obligations. In the case of banks, the core part
of their liquidity is the current balances held with the central bank. Banks
can draw on these at any time and receive instant value. In Australia, banks'
funds at the RBA are held in Exchange Settlement (ES) accounts.

The supply of ES funds is controlled by the RBA through daily operations in the money
market. The RBA varies the supply of ES funds so as to influence the interest
rate at which banks borrow and lend funds to each other. This interest rate,
known as the cash rate, is the rate in terms of which monetary policy changes
are announced. When the RBA wishes to add funds to the banking system, it
purchases securities, giving the seller funds in exchange. Sales of securities
by the RBA reduce the supply of ES funds.

Banks' demand for ES funds is normally fairly stable, being based on their expected
payment flows. Demand for ES funds can increase substantially, however, in
times of uncertainty as banks are less confident about their payment flows
and, as a precaution, seek to increase their holdings of liquid balances.
Hence, one of the RBA's priorities on the morning of 12 September was
to ensure that there were sufficient funds to meet banks' demand, in order
to avoid disruption to markets and increases in interest rates. When markets
opened in Australia on the morning of 12 September, the RBA issued a statement
that payments and settlement systems were operating normally and that it would
provide the financial system with liquidity as needed.

Early indications pointed to a sharp increase in the demand for liquidity on the
day. Banks expecting to receive payments arising from international transactions
were uncertain whether those payments would be received. As a result, they
became less willing to lend funds themselves.

The RBA injected significant additional ES funds through its market operations on
12 September. In its normal dealing round (which takes place between 10 and
10.15 am) the RBA boosted the supply of funds to about $2.5 billion, or around
three times the amount banks typically hold. The RBA normally only deals once
a day but, on this occasion, it undertook a second round of market operations
to add further funds later in the day when it was possible to form a clearer
view on the demand for funds. This boosted the amount of funds that banks
held in their ES accounts at the end of the day to over $5 billion (Graph
C1).

Graph C1

The demand for ES funds remained unusually high for a few days subsequently, with
balances averaging about $3 billion over the week. By late September, normal
conditions had returned to the market.

The increased supply of liquidity allowed the money market to continue to operate
smoothly throughout the period, with the cash rate remaining very close to
the target (Graph C2).

Graph C2

Box D: Share Market Performance and Share Buy Backs

Despite the weakness in the US share market over the past 18 months or so, US share
prices have, on average, risen faster than those in Australia over the past
decade (Graph D1). Since end 1989, the increase in the S&P 500 index has
exceeded that in the ASX 200 by an average annual rate of 3.8 per cent. Many
factors have influenced these outcomes. Amongst them are the low dividend
payout ratio and the high level of share buy backs in the US.

Graph D1

Dividends are very much a part of the return to shareholders and should be included
in any assessment of relative returns. Since end 1989, the Australian ASX
200 Accumulation Index, which takes into account dividends, has recorded an
annual compound rise of 10 per cent, compared with 12 per cent for the S&P
500 accumulation index (Table D1). This margin is substantially narrower than
that in the respective price indices.

Table D1: Share Market Returns

Per cent, per annum

Price index

Accumulation index

ASX 200

S&P 500

ASX 200

S&P 500

1989–2001

5.9

9.7

10.2

12.3

1989–1995

4.9

9.7

9.5

13.1

1996–2001

6.9

9.8

10.9

11.4

1998–2001

5.8

2.3

9.6

3.7

Source: Bloomberg

The narrower margin between the US and Australian accumulation indices is due to
higher dividend payments in Australia. Australia's dividend yield has
averaged 4 per cent since end 1989, around double that of the US. This higher
yield reflects a higher dividend payout ratio (around 80 per cent), which
was encouraged by the introduction of dividend imputation in 1987. The earlier
downward trend in the payout ratio has been largely reversed since (Graph
D2). In contrast, the US dividend payout ratio has fallen sharply since the
early 1990s, to now stand at about 40 per cent.

Graph D2

The effects of share buy backs on returns are more difficult to assess. In theory,
it can be argued that share buy backs should not affect the price of a company's
shares. To buy back its own shares a company must spend funds that it would
otherwise have used to generate future income. A buy back, therefore, reduces
a company's market value. But the number of shares outstanding is reduced
by the same proportion, leaving the price per share unchanged.

On the other hand, empirical studies investigating buy backs in the US market find
that buy backs lead to both a short-term price increase and longer-term market
out-performance. In any event it should also be noted that, even if a buy
back does not directly affect a company's share price, the share price
will nonetheless be higher than if the company had paid an equivalent amount
in dividends. A payment of dividends reduces the value of the firm but does
not change the number of shares outstanding.

Total buy backs for the US equity market in the five years ending December 2000 amounted
to over US$1 trillion, or 7 per cent of current domestic capitalisation. Australian
share buy backs totalled A$28 billion over the same period, or 4 per cent
of market capitalisation.

As a result of the high level of buy backs, the US equity market has recorded only
four significant quarters of positive net equity raisings since 1995 (Graph
D3). In comparison, Australia has had only one quarter of net buy backs in
that period. The high rate of buy backs in the US has meant that US net equity
raisings have averaged – 0.15 per cent of total market capitalisation
since 1995, compared with an equivalent figure of 0.5 per cent for Australia.

Graph D3

In the US, both the non-financial and financial sectors have run down their equity
stock over the last five years. Net raisings by the non-financial and financial
sectors amounted to US$–761 billion and US$–93 billion respectively.
The only sector to record positive net equity issuance has been foreign corporates,
which made net raisings of US$456 billion. The use of buy backs in Australia
has generally been modest, though significant use of them was made by financial
institutions.

Assessment of Financial Conditions

Financial conditions have eased further since the last Statement, with the cash rate now at its lowest level in almost 30
years. Interest rates on loans from intermediaries and financial market debt
instruments are also at historically low levels. While household borrowing
continues to rise strongly, business financing has been more subdued, reflecting
softer demand for funds. As described in the chapter on ‘Domestic Financial Markets’,
the domestic equity market has been volatile, but remains within 6 per cent
of its peak. The yield curve has maintained its positive slope and the exchange
rate remains at an historically low level.

Interest rates

The 25 basis point reductions in the cash rate in September and October have taken
the cumulative easing this cycle to 175 basis points. The magnitude of the
easing cycle remains comparable to most major countries, with the notable exception
of the US where the relatively weaker outlook has prompted a more aggressive
monetary policy response.

While changes in interest rates attract much attention and can have an influence
on consumer and business sentiment, the level of interest rates is likely to
be of greater importance for economic activity. In both nominal and real terms,
interest rates across the yield curve and most lending rates of intermediaries
are at, or around, the lowest in almost 30 years. As outlined in previous Statements, one approximate benchmark for assessing the stance of
monetary policy is the average real cash rate over the period since 1992, during
which there has been, on average, stable inflation and favourable growth outcomes.
The current level of the real cash rate, calculated using core inflation, remains
substantially below this average (Graph 74). Against this benchmark, real
borrowing rates charged by intermediaries are lower again because of the reduction
in interest rate margins charged over the course of the 1990s.

Graph 74

The slope of the yield curve (beyond maturities of around one year) has remained
broadly unchanged in recent months (Graph 75). (At the very short end,
the yield curve is negatively sloped reflecting market expectations of further
easing in monetary policy in the period ahead.) The current positive slope
is consistent with perceptions of accommodative monetary policy and continued
economic growth.

Graph 75

Market-determined interest rates on lower-rated corporate debt suggest a somewhat
more cautious outlook in the wake of the terrorist attacks in the US, with
spreads to lower-risk government debt generally widening, although the level
of yields across the credit spectrum remains relatively low.

Financing activity

Credit grew at an annualised rate of around 8 per cent over the six months to September.
This slowdown in credit growth masks quite disparate borrowing behaviour by
households and businesses (Graph 76).

Graph 76

Households continue to borrow at a rapid pace, with household credit rising at an
annualised rate of 17 per cent over the six months to September. The strength
in household borrowing reflects a significant increase in lending for housing
to both owner-occupiers and investors underpinned by the low level of mortgage
interest rates and, to a lesser extent, the First Home Owners' Grant scheme.
The current high level of loan approvals suggests that household borrowing
will remain strong in the coming months.

In contrast, business credit has declined slightly over the same period. The general
weakness in business credit – notwithstanding considerable volatility
in the monthly data which possibly reflects the impact of the new tax system
on the seasonal pattern of business borrowing – is consistent with businesses'
uncertainty regarding the economic outlook. Business loan approvals also remain
at low levels. Lower intermediated borrowings have been only partially offset
by solid growth in business funding raised directly through debt and equity
markets. While market financing conditions became less favourable in the wake
of the US terrorist attacks, causing the postponement of some debt and equity
issues, both equity prices and bond yields remain positive for corporate financing.

Growth in the broader monetary aggregates has picked up recently: M3 and broad money
grew at an annualised rate of 13 and 9 per cent respectively over the six months
to September. Growth in the monetary aggregates has outstripped that in credit,
as net offshore borrowing by financial institutions – a funding source
not included in the monetary aggregates – has slowed.

Real exchange rate

As discussed in the chapter on ‘International
and Foreign Exchange Markets’,
the Australian dollar has been volatile in recent months but is currently around
its average over the past year. The real exchange rate, which adjusts for differences
in inflation across countries, is also currently close to its level of a year
ago but 15 per cent below its 1990s average. This is likely to provide an ongoing
impetus to the traded sector of the economy (Graph 77).

Graph 77

Inflation Trends and Prospects

Recent developments in inflation

Consumer prices

The Consumer Price Index (CPI) increased by 0.3 per cent in the September quarter
to be 2.5 per cent higher over the year (Graph 78). Inflation measures
are now largely unaffected by the direct effect of changes to the tax system,
but fluctuations in the price of petrol continue to have a significant influence.
Petrol prices fell by over 8 per cent in the September quarter and are 7½per
cent lower over the past year. As a result, the decline in petrol prices subtracted
almost ½ a percentage point from the latest quarterly and annual rates
of inflation.

Graph 78

The various measures of underlying inflation were around 0.7 per cent in the September
quarter, down from rates of around 0.9 per cent in the March and June quarters
(Table 17). Thus, year-ended underlying inflation has risen from 2½
per cent in mid 2000 to around 3 per cent currently. This pick-up largely reflects
some flow-through of accumulated upstream price pressures relating to the fall
in the exchange rate over the past couple of years and increases in world prices
which have flowed through to items such as food. These pressures are evident
in the rise in annual growth of the tradables component (excluding petrol)
of the CPI from zero at the beginning of 2000, to 3½ per cent over the
year to the September quarter (Graph 79). Tradables prices (excluding
petrol) are rising faster than non-tradables prices for the first time in six
years.

In the latest quarter, however, there are signs that some of this pressure may be
abating. The tradables component of the CPI, excluding petrol, increased by
0.2 per cent in the September quarter, after rising by around 1½ per
cent in each of the two previous quarters. To some extent the reduction in
upward pressure on tradables prices reflects a levelling off in the exchange
rate since the end of 2000. In import-weighted terms, the exchange rate had
fallen by 14 per cent over the previous year and a half.

The proportion of tradable items recording price rises in the quarter also declined,
having risen sharply in the first half of the year, with large price falls
recorded for a number of tradable items. Clothing prices declined by nearly
2½ per cent in the September quarter, continuing the trend of the past
year as retailers have sought to run down unwanted inventories. This should
ease as inventories return to desired levels. Vegetable prices fell by more
than 8 per cent in the quarter, and have now substantially unwound the flood-related
rise in the March quarter. The large fall in petrol prices – their steepest
decline since the Gulf War – reflected lower crude oil prices and tighter
refinery margins. A further fall in the petrol component of the CPI in the
December quarter is in prospect if the crude oil price, in Australian dollar
terms, remains around its current level (Graph 80).

Graph 80

These falls were offset by large rises in the prices of a number of other food items.
The price of meat products, in particular, has risen faster over the past year
than at any time in the past two decades as a contraction in world supply,
due to the outbreaks of livestock diseases, has increased world meat prices.
Higher world prices for grain and flour have also led to an increase in the
price of cereal products. Prices have risen for dairy products, though for
milk this only partially unwinds the large fall in prices experienced in the
latter half of 2000. Fruit prices also rose due to supply shortages.

In contrast to the moderate outcome for tradables, the price of non-tradable products
increased by a little over 1 per cent in the quarter, after recording outcomes
of around ½ a per cent in each of the three previous quarters. House
purchase prices, which had risen very little in the previous three quarters,
rose by just under 1 per cent in the September
quarter, reflecting the recovery in activity in the housing sector.

A number of other non-tradable service prices also rose strongly. Insurance service
prices increased by 2.7 per cent
in the quarter, and are 7 per cent higher over the past year owing partially to an
easing in competitive pressures in the industry. Utility prices, which have
generally been stable over the past few years (after excluding the effect of
the GST), rose by 3 per cent in the quarter
due partly to the cessation of the ‘Winter Power Bonus’ in Victoria,
which had reduced household energy bills by $60 over the past three years.
Airline ticket prices, as measured in the CPI, are yet to show the impact of
recent developments in the airline industry – the demise of Ansett and
the reduction in international air travel – as these events occurred
late in the quarter.

Producer prices

Input cost pressures, after peaking in the second half of 2000, have moderated over
the course of 2001, aided by a decline in import prices (Graph 81). Producer
price inflation over the past year is now running at around 3 per cent at all stages of production (Table 18).
This is well down on the rates in late 2000, suggesting that inflationary pressure
from this source has eased considerably in recent quarters.

Graph 81

Table 18: Stage of Production Producer Prices

Percentage change

Sep qtr 2001

Year to Sep qtr 2001

Preliminary

−0.1

2.9

– Domestic

0.4

2.9

– Imported

−3.3

3.1

Intermediate

0.2

3.5

– Domestic

0.7

3.4

– Imported

−3.3

3.9

Final(a)

Domestic

0.3

2.1

– Consumption

−0.3

2.3

– Capital

0.9

2.0

Imported

−2.7

5.2

– Consumption

−2.4

5.5

– Capital

−3.0

4.9

Total

−0.3

2.7

– Consumption

−0.7

2.8

– Capital

0.2

2.5

(a) Excluding exports

Source: ABS

In the most recent quarter, widespread falls were recorded in the prices of imported
goods. The fall in the price of electrical machinery was particularly large,
with office equipment prices falling by more than 10 per cent in the September
quarter. Oil prices also fell, with the Asian benchmark oil price declining
by 9 per cent in the quarter.

These falls were offset by price rises for most domestically produced items. The
price of food again rose markedly in the September quarter due to higher prices
for meat, grain and dairy products. The rate of inflation for domestically
manufactured goods (excluding petrol and basic metal products) slowed in the
September quarter, but in annual terms it still remains high at 4½ per
cent. Increased activity in the housing sector raised the cost of construction
output by almost 1 per cent in the September quarter, after declines in each
of the past two quarters. Inflation in the property and business services sector
continued at a steady pace overall, but with some variation across industries.
The cost of computer consultancy services fell by ½ a per cent in the
September quarter, reflecting widespread weakness in demand, while fees for
legal services rose by 4½ per cent.

Some upward pressure on business costs is likely to emanate from the insurance and
electricity industries. Businesses are reported to have experienced large increases
in commercial insurance premiums in recent quarters, reflecting the withdrawal
of some low-cost competitors from the market, lower investment returns for
insurance companies and an increase in the number of global catastrophes. While
the effect of the terrorist attack on the global insurance industry remains
uncertain, the inevitable contraction in the supply of reinsurance suggests
that upward pressure on commercial premiums is likely to be maintained in the
short term. Businesses are also reporting increases in the price of electricity,
particularly at the wholesale level, as some of the large price falls that
occurred through the second half of the 1990s are unwound (see Box E).

Most major business surveys support the view that inflationary pressures from input
cost increases have abated from the pace recorded in 2000. The economy-wide
NAB business survey shows that purchase costs increased by 0.6 per cent in
the September quarter, their slowest rate for 18 months, with a further slowing
expected in the December quarter (Graph 82). Similarly, both the ACCI-Westpac
and Australian Industry Group surveys indicate that fewer manufacturers are
reporting rising costs than in previous quarters. Business expectations for
product price inflation are more mixed, but, in general, fewer firms are expecting
to raise prices than at the same time last year.

Graph 82

Labour costs

The various measures of wages generally indicate that labour costs remain contained
following a modest acceleration in the growth of some of these measures over
the course of 2000. The Wage Cost Index (WCI) increased by 3.7 per cent over
the year to the June quarter 2001, the same annual rate as in the previous
quarter, with similar growth recorded in both the public-sector and private-sector
components (Graph 83). This levelling-out in wages growth is consistent
with data for new enterprise agreements. The average annualised wage increase
in federal enterprise agreements certified in the June quarter was 3.9 per
cent, slightly lower than that recorded in the latter part of 2000 (Graph 84).
Wage increases under existing federal agreements have remained little changed
over the past year and a half at 3.7 per cent.

Graph 83

Graph 84

Growth in average weekly ordinary-time earnings (AWOTE) remains firm, rising by 2.2
per cent in the June quarter, to be 5.3 per cent higher than a year ago. The rise
in the quarter was well above growth in most other indicators and is likely
to reflect compositional problems that beset the Average Weekly Earnings survey.

According to the Mercer Cullen Egan Dell (MCED) Quarterly Salary Review, the average annual increase in office workers'
wages was little changed in the September quarter at 4.4 per cent, while growth
in executive salaries remained around 4¾ per cent. Recent business surveys
indicate that wages growth remains contained, with the NAB quarterly business
survey reporting that labour costs continued to grow modestly in the September
quarter. Both the NAB economy-wide survey and the ACCI-Westpac survey of manufacturers
reported that firms are having little difficulty attracting suitable labour.

The Australian Council of Trade Unions announced in late October that it intends
to make an application to the Australian Industrial Relations Commission (AIRC)
to vary award rates of pay. The claim, which will be heard as part of the Safety
Net Review early next year, seeks a $25 per week increase in pay for all award
workers. Last year, the AIRC granted increases of between $13 and $17 per week.

Inflation expectations

The inflation expectations of consumers have been relatively steady over the past
few quarters after recording strong rises over the year prior to the introduction
of the GST (Graph 85). The Melbourne Institute indicates that consumers'
median expectation for inflation over the coming year was 4.5 per cent in October,
unchanged from September; this series has exceeded the actual rate of inflation
throughout most of the past decade.

Graph 85

Business expectations for inflation have also remained steady. The NAB business survey
indicates that retailers expect to increase prices by 0.7 per cent in the December
quarter. Over the medium term, less than one in ten respondents expect inflation
to average more than 4 per cent, while one-third of respondents expect inflation
to be below 3 per cent. Longer-term inflation expectations of investors, as
measured by the difference between nominal and indexed 10-year bond yields,
have fallen over the past three months and are back around the low levels recorded
in late 1997 and 1998.

Most financial-market economists surveyed by the Bank have revised down their inflation
forecasts following the release of the September quarter CPI. The median inflation
forecast for the year to June 2002 declined from 2.3 per cent in the August survey, to 2.0 per
cent in the latest survey (Table 19). The median inflation forecast for
the year to June 2003 was 2.2 per cent. Most respondents' forecasts still
incorporate the assumption that over the next couple of years, the exchange
rate will appreciate. Trade union officials, as surveyed by the Australian
Centre for Industrial Relations Research and Training (ACIRRT), have revised
down their expectations for inflation over the year to June 2002 in the November
survey, unwinding the sharp increase reported in the May survey. Union officials
generally expect inflation to remain around 3 per cent over the year to June
2003.

Table 19: Median Inflation Forecasts

Per cent

Year to June 2002

Year to June 2003

May 2001

August 2001

November 2001

August 2001

November 2001

Market economists(a)

1.9

2.3

2.0

2.5

2.2

Union officials(b)

4.5

4.0

2.9

3.8

3.1

(a) RBA survey (b) ACIRRT survey

Inflation outlook

After a period in which it was boosted by the rise in the price level associated
with the changes to the tax system, CPI inflation was 2½ per cent over
the year to September. The various measures of underlying inflation suggest
that it has picked up slightly from around 2½ per cent in mid 2000 to
around 3 per cent currently. This increase in underlying inflation reflects
the pass-through of various cost pressures, in particular those relating to
the large decline in the exchange rate over the past couple of years and higher
oil prices.

Some of these cost pressures appear to have eased in the latest quarter, as reflected
in the producer price data and in a number of business surveys. Petrol prices
fell sharply in the September quarter, and are lower still in the December
quarter. Although the exchange rate has been reasonably stable, import prices
(excluding petrol) fell sharply in the September quarter. This may reflect
downward pressure on world prices from the deteriorating global outlook. This
is already evident in the prices of electronic equipment, but could become
more pervasive if global demand remains weak. The ongoing effects of the earlier
decline in the exchange rate on prices for tradables would, in most circumstances,
be expected to result in quarterly CPI inflation remaining higher than normal
in the period immediately ahead, as profit margins on import sales are gradually
restored. But it is possible that the process of margin re-building could occur
in part by a decline in foreign-currency prices for imports, with less pressure
on final prices to the consumer. This outcome appears to be more likely now
than was the case six months ago.

There are several industry-specific factors that will work in the opposite direction
over the next year or so, placing some upward pressure on business costs. Businesses
are already reporting large increases in commercial insurance premiums, which
are likely to continue as reinsurance premiums are raised. Wholesale electricity
prices are rising, after a period of declining real electricity prices, with
some businesses experiencing particularly large price increases for long-term
contracts.

There are also some industry-specific developments that will affect consumer prices
more directly. The rebound in the housing market is already feeding through
into increases in house purchase costs and this pressure is likely to intensify
in the coming quarters. The recent changes to the structure of the airline
industry have put upward pressure on the cost of air travel, though this is
not yet evident in the CPI. More generally, competitive pressures have helped
cap price rises in the insurance, telecommunications and airline sectors over
the past decade. The exit of a number of businesses from these industries in
recent months may result in some rise in prices in these areas.

Nevertheless, competition remains strong across many sectors, and businesses are
likely to find it difficult to raise prices significantly while there remains
appreciable spare capacity in the economy. The current subdued state of the
labour market, and the prospect that this will persist for some time, means
that growth in labour costs should remain well contained and may slow. Together
with the general easing in cost pressures, this increases the scope for some
margin re-building without strong pressure on consumer prices.

The Bank's assessment is that underlying inflation, measured on a year-ended
basis, will reach a little over 3 per cent in the next couple of quarters,
before declining to around 2½ per cent through 2002. In the near term,
CPI inflation is likely to remain below underlying inflation due to the decline
in petrol prices. This assessment is based on the usual assumption that the
exchange rate remains around recent levels, though international oil prices
are assumed to drift slightly higher over the coming year in response to reductions
in oil production.

Risks to the forecast can be identified in both directions. Inflation could be higher
than forecast if the world economy were to recover faster than is currently
anticipated, lessening the assumed downward pressure on world prices. The possibility
of higher oil prices, given the current military tensions, constitutes another
upside risk to the outlook for inflation. A sharp and sustained rise in the
price of oil would feed directly into consumer prices, but there would also
be an indirect effect through higher business costs.

On the other hand, inflation could be lower than forecast if the downturn in the
global economy were to be deeper or more protracted than currently assumed.
Such a scenario could result from the recession in the US economy being worse
than the Consensus forecasts currently imply. In addition to causing larger
declines in world prices, the weaker world economy could translate into slower
demand growth in Australia and hence, in time, further constrain domestic wage
and price increases. Currently, the Bank considers these risks to the central
forecast, over a one to two year horizon, to be slightly weighted towards the
downside.

Box E: Electricity Prices

The electricity industry in Australia has changed substantially over the past decade.
A range of administrative reforms and the introduction of competition to parts
of the industry have been associated with significant productivity gains and,
for much of the period, declining real electricity prices. However, in recent
months there has been upward pressure on electricity prices, with some customers
experiencing particularly large price increases.

Reforms implemented over the past decade have resulted in the separation of the components
of electricity supply – generation, transmission, distribution, and
retail supply. Competition was introduced into the generation of electricity
by dividing the power stations into separate corporate entities, initially
in Victoria and NSW and later in other states. Competition has also been introduced
to parts of the retail electricity market. At this stage, large and some medium-sized
users of electricity in most states have the choice of retail supplier –
that is, in the parlance of the industry, users are deemed to be ‘contestable’.
All users in NSW and Victoria are expected to be able to choose their electricity
retailer next year. South Australia plans to adopt full retail contestability
later than in these states, while Queensland has decided not to proceed.

Another key development was the establishment in December 1998 of the National Electricity
Market (NEM), which connected the individual electricity grids of NSW, Victoria,
Queensland, South Australia and the
ACT.[1]
It allows the transmission of electricity across these regions' borders.

Electricity price developments

Movements in final electricity prices can largely be traced to two components: anenergy charge which mainly reflects movements in wholesale electricity
prices, and network charges levied on electricity retailers by electricity
distributors, reflecting the costs of building and maintaining the electricity
distribution and transmission network. As a rough guide, for medium-sized
businesses the energy charge comprises at least 50 per cent of the final electricity
price.

The reforms in the electricity industry were associated with a decline in electricity
prices faced by businesses and a slowing in the growth of electricity prices
faced by households (Graph E1). Large and medium-sized businesses in Victoria
and NSW who were contestable benefited from falls in electricity prices during
1996–1998, underpinned by the low wholesale price of electricity as
generators competed for market share (Table E1) and, more recently, falling network
charges. Businesses in South Australia also experienced lower prices in this
period. However, over the past few years, wholesale prices have risen which,
along with expected smaller future reductions in network charges, have been
feeding through to higher final electricity prices as businesses in these
states renegotiate their electricity contracts.

Graph E1

Table E1: Average Wholesale Spot Electricity Prices(a)

Dollars per megawatt hour

State

1994

1995

1996

1997

1998

1999

2000

2001(b)

NSW

–

–

24.1(c)

17.5

19.4

22.7

35.7

34.7

Victoria

46.7(d)

42.2

19.9

18.8

18.3

22.6

38.3

38.3

Queensland

–

–

–

–

–

41.6

50.3

37.2

SA

–

–

–

–

–

54.5

57.2

46.2

(a) Prices only available since the commencement of each state's wholesale
spot market (b) Until 31 October (c) May 1996 to December 1996 (d) July 1994 to December 1994

Source: NEMMCO

In South Australia, where many additional business users have just become contestable,
electricity prices are increasing substantially. This partly reflects the
artificially low prices contained in their previously regulated contracts,
but also a perceived increased risk that tighter supply of electricity in
the summer months may cause large spikes in wholesale electricity prices,
as occurred last summer (Graph E2).

Graph E2

In contrast to larger businesses, the supply of electricity to households and smaller
businesses is only now becoming contestable in NSW and Victoria. In Victoria,
the government has reserved the right to oversee the setting of electricity
prices in that state. In NSW, households have the option until mid 2004 of
remaining on (or returning to) a regulated contract which limits the price
rise to that of the total CPI. In South Australia and Queensland, price rises
of around 3 per cent have been determined for 2001/02.

Effects on the CPI

Electricity prices affect the CPI directly through households' consumption of
electricity, and indirectly as changes in input costs faced by businesses
are passed on to prices of other goods and services. Electricity has a weight
of 1.8 per cent in the CPI and, in the near term, as the majority of households
will be covered by regulated contracts containing subdued price increases,
the direct effect on inflation will be fairly small. Although electricity
comprises less than 2 per cent of total intermediate inputs used in production,
it accounts for much more in selected industries – electricity comprises
up to 8 per cent of intermediate inputs in parts of the manufacturing industry.
The size of recent price increases for some businesses will have a significant
effect on their overall costs and may feed through to consumer prices.

Footnote Box B

For statistical purposes, a tourist is defined as a person travelling to, and staying
in, places outside their usual place of residence for up to one year. They
may be travelling for leisure, business or other purposes, but must not receive
remuneration from the place visited.
[1]

Footnote Box E

Tasmania is scheduled to join the NEM in the near future. Although distance may preclude
Western Australia and the Northern Territory
from joining the NEM, they are also implementing electricity reforms.
[1]